As a business owner, having a firm understanding of how financial ratios work helps you get a handle on how well your company is doing. Ratio analysis, when applied correctly, allows you to evaluate your company’s health and performance, as well as its strengths and weaknesses.
It may help detect any potential issues from early on and has even been known to predict future bankruptcy. In this article, we examine 4 fundamental financial ratios that business owners need to know and monitor regularly.
#1 Accounts Receivable Turnover
This efficiency ratio measures the number of times a business collects its receivables or credit extended to customers in a year.
Why it matters:
It allows companies to evaluate how efficient they are at issuing and collecting credits, which is vital for maintaining a healthy cash flow.
According to Consero, a high accounts receivable turnover suggests that a company has an efficient business operation and well-organised credit collection policies. This is viewed favourably from a cash flow standpoint. Conversely, a low receivable turnover indicates that a company has trouble collecting credits from customers. This could point to an inadequate collections function or an excessive amount of bad debt.
Because there is an opportunity cost involved in holding credit for a longer period of time, companies with low receivables turnover should reevaluate their credit policies to ensure more timely collections from customers.
#2 Accounts Payable Turnover
This liquidity ratio measures a business’s short-term liquidity or ability to pay its debts from the speed in which it pays its vendors or suppliers in a year.
Why it matters:
Investors may use this ratio to determine whether your company has enough cash or revenue to meet your short-term financial obligations. It helps to decide whether or not to invest in your business. Meanwhile, creditors (or banks) can use this ratio to measure whether to extend a line of credit to your company.
According to Investopedia, a higher ratio shows that you pay your bills frequently and regularly, and can be used to negotiate more favourable credit terms, such as early payment discounts. It also inspires confidence in new vendors, as it implies they will be paid promptly.
However, while it’s good to pay off your vendors quickly, paying them too quickly could mean that you’re not utilising your cash properly for other endeavours, such as expanding or enhancing areas of your business. This is why, it’s not always a good sign if your ratio is much higher than other companies within the same industry.
#3 Current Ratio
This liquidity ratio helps determine your business’s ability to pay off its short-term liabilities with its current assets within a year.
Why it matters:
For business owners, this ratio offers insight into whether your business could stay afloat amid undesirable circumstances such as slowing sales, delinquent payment from clients or economic recession.
A current ratio that is greater than 1.0 puts your company in a “safe” zone, as it suggests you have more short-term assets than short-term liabilities. Meanwhile, a ratio that’s less than 1.0 could be a warning sign that you could run short on cash over the course of the next year unless you find a way to generate revenue more quickly.
The ratio also serves as a yardstick for external stakeholders who are looking to do business with you. They could range from potential partners or investors who want to understand your company’s solvency, to suppliers trying to determine if you’re a good paymaster.
According to Harvard Business Review, bankers pay close attention to this ratio and may even include in loan documents a threshold current ratio that borrowers need to maintain, which is typically 1.1 or higher.
#4 Debt to Equity Ratio
This solvency ratio shows how capital has been raised to finance a business (or its assets). The greater the ratio, the more debt is being used instead of equity in a business.
Why it matters:
For entrepreneurs or startup owners, this ratio is used when applying for a loan or business line or credit. According to Hubspot, it’s an important metric because it indicates your company’s stability and ability to raise additional capital.
For investors, this ratio is used to assess how risky it is to invest in a company. The higher the debt to equity ratio, the riskier the investment.
A healthy debt to equity ratio ranges from 1 to 1.5. However, capital-intensive industries such as finance and manufacturing do tend to use more debt financing than others, and typically have higher financial ratios that can be greater than 2.
Beyond The Numbers
When looking through these ratios, keep in mind that they are just one of the many ways to assess your company’s financial performance. What constitutes a healthy ratio also differs between industries, so it is important that you benchmark your business against businesses of a similar industry, size and geographical location.
Ultimately, ratios and figures can only serve as a guide, and it is up to the savvy entrepreneur to make sense of data, and make wise decisions according to their company’s unique situation and business environment.
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