Preparing your company's financial statements can be a daunting task for any business owner if you don't have the help of a professional financial accountant. Furthermore, the importance of properly preparing these statements becomes even clearer when you understand their usefulness beyond simply listing your company's assets, liabilities, income and expenses.
Financial ratios are used to translate the various financial items that arise from your company's activities into approximate benchmarks against which you can evaluate of your business' performance. However, it must be noted that while many of these benchmarks are widely accepted in the business community, each industry and each company has unique circumstances and features that can reduce the effectiveness of financial ratios as performance indicators. Nevertheless, although these ratios should not be used as absolute measurements, they can act as guides which, when combined with effective strategic management, allow you to identify areas within your business that can be improved.
Listed below are several of the most widely used financial ratios:
Current ratio:
Defined as your company's Current Assets (in $) divided by Current Liabilities, the Current ratio indicates how quickly a company's assets can be liquidated to cash. Based on the formula below, the standard 2:1 Current ratio means that at least half of Current Assets are financed by long-term liabilities/sources of funds.
Current Assets ( in $) / Current Liabilities (in $)
Quick ratio:
This measure of a company's ability to meet short-term obligations is also known as the acid test. The Quick ratio differs from the Current ratio in its exclusion of inventory, as this key liquidity ratio focuses on the firm's more liquid assets.
A firm's quick ratio can be of interest to owners and investors anticipating some kind of downturn in the firm's business or the economy at large by helping to answer the question: "Could this firm meet its current obligations with the readily convertible assets on hand if sales were to cease today?"
In general, the quick ratio should be 1 or higher. A company with a Quick ratio of 1 or more is less likely to be in danger if its sales or its entire industry suffers a temporary downturn, as there should be sufficient liquid assets to cover current liabilities.
Cash + Receivables / Current Liabilities
Inventory Turnover ratio:
This ratio measures how many times the inventory of a firm is sold and replaced during an accounting period. A turnover rate that is lower than the industry average might indicate a company is carrying excess inventory, which ties up resources the company could invest in other ventures and making the firm more vulnerable to falling prices.
Since sales are recorded at market value and inventories are normally carried at cost, it would be more accurate to obtain the turnover ratio by dividing inventory into cost of goods sold rather than into gross sales. However, because most financial institutions and analysts use sales as the numerator, it may be best to do the same to ensure comparability to other firms.
Annual Sales / Inventory
The ratios listed above are only a small sample of the many utilized by businesses in all industries; the key to successful planning for an owner/operator like you is recognizing their value as tools for assessing your company's performance.
