Calculating financial ratios is an important component of analyzing a business that can be extremely helpful to business owners. By using the information from your business' financial statements, you can calculate several useful financial ratios that can help you analyze how successfully your business is operating.
Some useful financial ratios to calculate
Here are some of the most common, and most useful, financial ratios you can calculate for your business, as well as links to more details about the most relevant ones.
1. Current ratio -- It's current assets divided by current liabilities, and is a good measurement of how well-covered your short-term liabilities are. A higher current ratio is a good sign of financial stability.
2. Quick ratio -- It's similar to the current ratio, but specifically excludes inventory from your business' current assets. In other words, it's a metric that tells your ability to pay your short-term obligations without liquidating your inventory. The quick ratio is also known as the acid-test ratio.
3. Inventory turnover -- It's your sales divided by the value of your inventory. This tells how many times per year you're turning over your inventory.
4. Average collection period -- It's receivables divided by sales, then multiplied by 360. This is the average time your business waits to get paid after making a sale.
5. Fixed assets turnover -- It's your sales divided by your fixed assets and can tell you how efficiently your business is using its buildings and equipment to generate revenue.
6. Total assets turnover -- It's your sales divided by total assets and tells you how efficiently you're using all of the assets your business owns to generate revenue.
7. Debt to total assets -- It's calculated by dividing your business' debts by the value of the assets it owns, and then expressing as a percentage. This is the percentage of your funds provided by creditors, and a lower percentage is generally preferable.
8. Times interest earned -- This ratio is also known as interest coverage, and is calculated by dividing your earnings before interest and taxes (EBIT) by the interest you'll pay annually. This tells you how much earnings can decline before you'll be unable to service your debts, and a higher ratio is better.
9. Profit margin on sales -- Also known simply as "profit margin," this is calculated by dividing your business' adjusted (taking excess owners' compensation into account) net income by your sales, and expressing the result as a percentage. For example, a 30% profit margin means you're earning $0.30 for every dollar in sales.
10. Earning power -- It's calculated by dividing your adjusted EBIT by total assets, and is a metric that shows how much of a return you're getting on your business' assets before considering debt servicing and taxes. It is most useful for comparing businesses with different debt levels and/or tax situations.
11. Return on assets (ROA) -- It's similar to earnings power, but the calculation uses adjusted net income (after taxes and interest) as opposed to EBIT. This is the actual return your business is generating on the assets it owns.
12. Return on equity (ROE) -- This is perhaps the best indicator of how much you (and your shareholders, if applicable) are earning on your investment. Return on equity is calculated by dividing your adjusted net income by your shareholders' equity.
Doing the math
Better yet, here's a calculator that you can use to enter all of your relevant business information, which will calculate all 12 of these financial ratios for you: