As an accountant, you’ll be called on to assess the financial health of your clients’ businesses. To accurately measure performance and identify areas for improvement and potential growth, you’ll need to use financial ratios. Here’s a quick introduction.
What are financial ratios?
Financial ratios – also known as accounting ratios – are a set of calculations that use the financial data of a business to express its performance as set values. Financial ratios are used to assess a range of things, such as:
What are they used for?
Accountants use financial ratios to assess the performance and financial health of a business. They’re particularly useful for comparing your business performance to others in your sector, your competitors, and the broader market. Financial ratios are also an effective way to track trends in your own business over time, evaluate investments, and identify problems.
Five common financial ratios
There are dozens of ratios for almost every piece of financial information. However, these five are the most common.
1. Break-even analysis
This ratio is often used by the sales department to work out the volume of sales required to break even. A break-even analysis tells you the number of products or services a business must sell to cover costs and start making a profit.
Break-even point = (total fixed costs / the average price of your product or service) – the average cost to make or deliver your product or service
2. Gross profit margin ratio
The gross profit margin ratio will tell you the proportion of profit a business makes on each dollar of sales before operating expenses. This is generally used to assess the profitability of a product or service.
Gross profit margin = gross profit / sales
3. Accounts receivable turnover ratio
How effective is a business at getting paid? A high accounts receivable turnover ratio means a business is on the right track when it comes to collecting their dues, while a low ratio shows there’s room for improvement.
Accounts receivable turnover = total sales / accounts receivable
4. Current ratio
Also known as working capital ratio, this figure measures the overall financial strength of a business. It looks at its ability to turn assets into cash to cover operating expenses and other liabilities. Generally, a high current ratio is a signal that the business is in good financial health.
Current ratio = current assets / current liabilities
5. Debt to equity ratio
All businesses need money to get up and running. This capital usually comes in the form of a bank loan (known as debt) or from equity – that is, a business’s own profits or private investment. The debt to equity ratio reveals the balance between debt and equity that is used to fund the business. Lenders will tend to favour a low debt to equity ratio.
Debt to equity ratio = total liabilities / total equity
Financial ratios are important tools for accountants and business owners. Use these five to assess your business’s financial health, see how it sits among the competition, and look for ways it can improve and grow.