4 Important Financial Ratios Every Business Must Know

Financial ratios are useful tools that help businesses and investors to analyse the financial health of a company. They are used to compare the relationship between different pieces of information taken from the financial statements of a company such as the income statement, cash flow statement and balance sheet.

A business must be well-informed of its cash position and overall financial health to identify the weak areas and make improvements for growth. That’s why its necessary to perform a few simple calculations and find out some significant financial ratios.

Our expert bookkeepers at Virtuous Bookkeeping have compiled a list of 6 important financial ratios that every business must know to get a good grip on its financial position to assist you.

1) Current Ratio

Current ratio, also referred as working capital ratio, is a liquidity ratio that represents the ability of a company to convert its assets into cash to pay its short-term obligations due within the next year. It is calculated as follows:

• Current Ratio = Current Assets / Current Liabilities

It is an important ratio because it helps to measure the liquidity position of a business. The higher the current ratio, the easier it is for the company to pay off its current debts. The ideal current ratio is 2:1 as it means that the company’s current asset is twice as large as current liabilities, thus stating that business is in a good position.

2) Quick Ratio

Quick ratio or acid test ratio is an indicator of a company’s short-term liquidity. It filters the current ratio as it measures the amount of most liquid current assets (assets that can be liquidated fast) to cover the current short-term liabilities. It is calculated as follows:

• Quick Ratio = (Cash and Equivalents + Marketable Securities + Accounts Receivable) / Current Liabilities

The liquid assets include those current assets that can be converted to cash within 90 days. This ratio excludes those assets that cannot be readily converted into cash within short time frame because the business needs to pay the short-term liabilities on time. The ideal quick ratio should be 1:1. If the ratio is higher than 1:1, it indicates that the business can easily meet its current liabilities with its quick funds on hand. On the contrary, if the ratio is lower than 1:1, it means that the business relies too much on inventory to pay off its short-term liabilities.

3) Debt-Equity Ratio

Debt-equity ratio is calculated to find out the company’s financial leverage. It is a significant ratio for the company because it indicates the amount of debt the business is using to finance its assets. The ratio can be calculated by using the following formula:

• Debt-Equity Ratio = Total Liabilities / Stockholder’s Equity

This ratio shows the relatability between the part of the assets financed by the creditors and the part of the assets financed by the shareholders. A ratio of 1:1 or 1 shows that both creditors and shareholders contribute equally towards the assets of the company. If the ratio is more than 1, it indicates that creditors’ contribution is greater than the shareholders’, whereas a ratio less than 1 indicates that shareholders have contributed more than creditors. Generally, creditors prefer a low debt-equity ratio as it shows that they have greater protection of their money whereas stockholders prefer a high ratio.

4) Solvency Ratio

Solvency ratio is an important metric that measures a business’ ability to pay its debts and obligations. It is necessary to calculate this ratio to find out whether the company’s cash flow is sufficient to meet its liabilities, both short-term and long-term. The formula is:

• Solvency Ratio = (Net Income + Depreciation) / (Short-Term Liabilities + Long-Term Liabilities)

This ratio indicates whether the company can stay solvent or not. If the ratio is higher than 20%, the business is likely to remain solvent whereas if the ratio is low, the business will be unable to pay off its debt obligations. However, the solvency ratio can differ from industry to industry.

The above-mentioned financial ratios provide an insight into the strengths and weaknesses of a business’ financial situation. Take them into consideration before making decisions or investing money. If you need help in handling these financial matters, then contact the experienced bookkeepers at Virtuous Bookkeeping.