Key Financial Ratios for Better Business Finances
With your latest financial statement in hand, review the following (too often ignored) key financial indicators and see how your business is fairing. This cheat sheet will help you to understand the implications of these ratios for the health of your business, and explain some financial terminology that may be unfamiliar.
Liquidity is simply the company’s ability to meet its obligations as they come due.
Some key indicators of strong liquidity are:
- Current Ratio = Total Current Assets / Total Current Liabilities
- If you have outside financing, you can bet that your banker is tracking this number for your business.
- The higher the number, the better position the company is in to meet its current schedule of obligations (those due within one year or less)
- Accounts Receivable Days = (Accounts Receivable / Sales )*365
- The lower the number, the less time on average between sales and receipt of payment.
Recommendations to improve liquidity:
- Be sure you are collecting money from customers more quickly than you are paying your vendors. If not, try to decrease customer collection time while extending those vendor credit terms a little longer if possible.
- Increased sales usually results in increased profitability as well as liquidity as long as the profits remain in the business.
Borrowing ratios are indicators of whether or not your business is borrowing profitably.
Key indicators for borrowing are:
- Interest Coverage Ratio = EBITDA / Interest Expense
- EBITDA (Earnings Before Interest, Taxes, Depreciation and Amortization) measures the ability to make debt payments from operating cash flow.
- The higher the ratio, the better indicator of credit quality.
- Debt to Equity Ratio = Total Liabilities / Total Equity
- Indicates the balance between money and assets owed versus the money and assets owned.
- Creditors prefer a lower ratio to decrease financial risk while investors prefer a higher ratio to realize the return benefits of financial leverage.
Recommendations to improve borrowing:
- Consider interest rates on existing loans. In these economic times, it may make sense to check into re-financing some of your current debt at a lower interest rate or over a longer period of time.
- Paying down debt will increase these ratios and improve credit worthiness.
Asset ratios are indicators of whether or not your business is using gross assets effectively.
Key indicators for assets are:
- Return on Investment “ROI” = Net Income / Total Equity
- Measures the amount of profit being returned on the shareholders’ equity each year.
- The higher the percentage, the more return the shareholders’ are getting for their investment in the business.
- This will be one of the most important ratios to potential investors.
- Return on Assets = Net Income / Total Assets
- Measures the ability to use the company’s assets to create profits.
- The higher the percentage, the more money the assets are making.
Recommendations to improve asset ratios:
- Increased sales and net income (without increasing equity or assets) will drive these percentages higher.
- Consider holding off on asset purchases unless you believe there will be increased sales and net income as a result of the new asset purchase.
It is important for you to not just know these numbers, but know what they mean for your business. Many times, these ratios can act as a red flag to alert you to deeper issues that can be addressed before it is too late. Take a few minutes to determine your ratios and speak to your advisors about these essential numbers.
Glass Jacobson’s team of financial experts can help you determine what these ratios mean to the future of your business, and point you in the right direction when it comes to decisions that will affect the outcome of these ratios and your bottom line. Meet our team, check out what services we offer, and contact us for more information.