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Guide

What Are Financial Ratios — and Why Are They Important?

Taking steps to monitor the health of your business? A good way to do this is to measure & monitor a number of different financial ratios. Here's how.

Many people today are monitoring the status of their health more closely to help stay in shape and identify possible health problems early. If you’re a small business owner, are you taking similar steps to monitor the health of your business?

 

A good way to do this is to measure and monitor a number of different financial ratios. These can be useful indicators of how well your company is performing in a number of different financial areas.

 

Most ratios are calculated from information derived from your company’s financial statements. These usually include your cash flow statement, balance sheet, and income or profit and loss statement (or P&L for short).

 

Important Financial Ratios: Which Should You Measure?

There are a number of different financial ratios that can be calculated, measured and monitored. So the first thing to do is decide which ratios to spend your time focusing on. You should base this decision on which areas of your business are the most important in terms of ensuring a smooth financial operation.

 

Cash flow is important for almost every business, so cash flow ratios are usually a good place to start. The primary cash flow ratios are:

 

  • Current ratio – Also known as the quick ratio or acid test ratio, this is a good indicator of your company’s short-term liquidity. It will tell you how many times current assets (not counting inventory) could be used to pay down current debt. If your current ratio is between 1.5 and 2.0, this is usually considered healthy.

    Current assets – inventory / Current liabilities
  • Accounts receivable days (or AR days) – Receivables collections are a vital component to ensuring strong cash flow, which makes this a critical ratio for most companies. This financial ratio indicates how many days on average it takes to collect your accounts receivable. The ideal number of AR days differs from one industry to the next, but 45 days is usually considered to be a good number to shoot for. It’s equally as important to monitor trends in AR days, as a growing number might indicate future cash flow problems.

    AR / Annual sales x 365
  • Days sales outstanding (or DSO) – This ratio is similar to AR days, as it measures the average number of days it takes to collect revenue after a sale has been made. The lower your DSO number, the better, since this indicates you are collecting money relatively quickly, and this can improve your cash flow. DSO is usually calculated on a quarterly or annual basis.

    Accounts receivable / total credit sales x Number of days

 

Other Important Ratios

Growth and profitability are other areas of your business’ performance that you can monitor by measuring select financial ratios. These include:

 

  • Debt-to-equity – Growth is an admirable goal, but small businesses must be careful not to grow too fast. This ratio will help gauge your company’s debt capacity — or in other words, how much additional debt you can safely assume. Bankers typically look for a debt-to-equity ratio of 2-to-1 or less when analyzing business loan requests.

    Total debt / Equity
  • Profit margins (gross and operating) – These ratios answer the all-important question: How much money is your company making as a percentage of sales? Gross profit measures profit before operating expenses are factored in, while operating profit includes expenses in the calculation.

    Gross profit / Sales

    Operating income / Sales
  • Earnings before interest, taxes, depreciation and amortization (or EBITDA) – This ratio is typically the key measure that investors and potential acquirers look at, since it offers the truest picture of your company’s profitability.

    EBITDA / Sales

 

Benchmark Your Most Important Financial Ratios

Finally, keep in mind that financial ratios in and of themselves may not be particularly useful. You should benchmark your financial analysis ratios against prior performance periods or industry averages to see if your company’s financial performance is improving or declining, as well as how you stack up against your competition.

 

Before you begin calculating financial ratios, create a Balance Sheet to determine your business’s assets and how much is still owed on those assets. For more information on financial ratios, please contact your Cadence Bank representative

 

 

This article is provided as a free service to you and is for general informational purposes only. Cadence Bank makes no representations or warranties as to the accuracy, completeness or timeliness of the content in the article. The article is not intended to provide legal, accounting or tax advice and should not be relied upon for such purposes.



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