How frequently do you enquire about the health of your business? Remember, it is not enough to simply check your profitability statements and your balance sheets. Along with these, you need to periodically check your business against the numbers that a handful of ratios throw up.
These ratios come from various areas – the business’s operations, inventory management, profits, loans, and investments. Big or small, new or old, financial ratios are a mirror of your business’s health. They help in:
• Keeping you updated about your current profitability and identify the components that are attributing to it
• Ascertaining the business’s solvency position and helping you plan your loan repayments judiciously
• Identifying the business’s strengths and weaknesses and hence, take adequate measures to stay on course
• Estimating future trends and make strategic plans Here are the top 5 ratios that you can bank on to speak the truth about your business:
Debt-Equity Ratio: • This ratio indicates the proportion of equity and debt used by your business to finance its assets.
• Calculated as Total Liabilities / Shareholders Equity
• Too high a debt-equity ratio indicates that your business is too dependent on outsider loans, while if the ratio is too low, it will indicate you are not taking optimum opportunity of available loans and are instead, risking your own capital.
• The ideal debt-equity ratio is 2:1
Current Ratio: • This ratio shows your business’s ability to pay back current/ immediate liabilities
• Calculated as Current Assets / Current Liabilities
• Too high a current ratio will indicate that your business is not utilizing its working capital optimally, while too low a ratio indicates that it’s short-term position is not very sound • The ideal current ratio is 2:1
Return on Investment:
• This ratio is a measure of performance • It evaluates the efficiency of an investment or to compare the efficiency of a number of different investments • Calculated as (Gain from the investment – Cost of Investment)/ Cost of Investment
• Net profit ratio is a key ratio of profitability
• It shows the amount of each sales rupee left over after all expenses have been paid.
• Calculated as Profit (after-tax) / Revenue
• A higher net profit ratio means that your business is more efficient at converting sales into actual profit.
Stock Turnover Ratio:
• This ratio measures how fast the inventory in your business is moving and generating sales
• Calculated as Cost of Good Sold/ Average Stock
• A higher ratio will indicate a slow-moving inventory while too low a ratio will mean that your business is not able to manage stock levels to meet sales demands Which are the ratios that you bank on for your business’s financial and performance analysis? Are they different from the ones we listed above?