Importance of Financial Ratios

Running a company involves continual examination and evaluation of its business performance. To ensure the continued profitability of your enterprise, use financial ratios to measure and evaluate it. The importance of financial ratios becomes evident when you compare important data such as assets and liabilities. Once you understand your margin of safety, you can make important decisions to run your business successfully.

A liquidity ratio – a useful indication of a company’s ability to manage short-term obligations – provides important information about business strength. When you seek a short-term business loan, you will be asked to calculate your liquidity ratios to prove overall financial well-being. An example of a liquidity ratio is the current ratio. You can calculate your current ratio by dividing your current assets by your current liabilities. The resulting figure indicates a dollar figure available to service every dollar of current debt in the business.

Sales and assets ratios help measure the efficiency of a business – how well it uses its assets. Use the accounts receivable turnover ratio to measure the way a business manages its accounts receivable. Divide the annual net credit sales by the average of the accounts receivable figures from the beginning and end of the period. The resulting figure indicates how many times receivables are collected on average during the year. Additionally, the inventory turnover ratio indicates how well a business manages its inventory. To calculate inventory turnover, you can divide annual sales by the annual average inventory, or you can divide the cost of goods sold by the annual average inventory. The answer indicates how often inventory was bought and sold by the business in one year.

Leverage ratios indicate how much debt or equity is used in the capital structure of a company . The debt-to-equity ratio divides the total liabilities by the total shareholder equity. The resulting figure indicates the amount of debt for each dollar of equity.

Profitability ratios compare profits to assets or equity. The return-on-assets ratio divides net profits (after taxes) by total assets. This indicates a company’s ability to produce profits from available assets. The return-on-equity ratio measures profits earned for funds invested in the company. To calculate return on equity, divide net profits by equity. The resulting figure indicates asset management and the strength of capital structure.

When evaluating and interpreting ratios, do not use a single reference point, as doing so will not provide a complete representation of a company. Instead, compare current ratios to earlier ratios. In addition, consider comparing current ratios to business forecast data and available data from competitors. Avoid using year-end data to calculate ratios because accounting balances may not be accurate during that accounting period.