David Bater

A Simple Explanation of Financial Ratios in Business

A Simple Explanation of Financial Ratios in Business

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Use these Financial Ratios and Quality Indicators in your Business. And, if you monitor the financial ratios on a regular basis, you’ll gain an insight into how effectively you are managing your business.

Why Use Financial Ratios

Lenders like to use financial ratios to evaluate risk.  They use several sets of ratios typically:

  • They use the financial ratio of assets to liabilities.
  • Also, the ratio of lender-investor pounds to owner-investor pounds.

Recognise that financial ratios are indicators and that only you can tell the full story about your business.  So the more adept you are at explaining your financial ratios to your lender, the better they’ll understand your business as they make a credit decision.

What Financial Ratios to Monitor

LIQUIDITY

Financial ratios in the liquidity category measure the company’s capacity to pay its debts as they come due.

Current Ratio

Definition: The ratio between all current assets and all current liabilities; another way of expressing liquidity.

Formula:

Current Assets
Current Liabilities

Analysis:

  • 1:1 current ratio means; the company has £1.00 in current assets to cover each £1.00 in current liabilities. Look for a current ratio above 1:1 and as close to 2:1 as possible.
  • One problem with the current ratio is that it ignores timing of cash received and paid out. For example, if all the bills are due this week, and inventory is the only current asset, but won’t be sold until the end of the month, the current ratio tells very little about the company’s ability to survive.

Quick Ratio

Definition: The ratio between all assets quickly convertible into cash and all current liabilities. Specifically excludes inventory.

Formula:

Cash + Accounts Receivable (Debtors)
Current Liabilities (Creditors)

Analysis:

  • Indicates the extent to which you could pay current liabilities without relying on the sale of inventory — how quickly you can pay your bills. Generally, a ratio of 1:1 is good and indicates you don’t have to rely on the sale of inventory to pay the bills.
  • Although a little better than the Current ratio, the Quick ratio still ignores timing of receipts and payments.

SAFETY

Indicator of the businesses’ vulnerability to risk. These ratios are often used by creditors to determine the ability of the business to repay loans.

Debt to Equity

Definition: Shows the ratio between capital invested by the owners and the funds provided by lenders.

Formula:

Debt Equity

Analysis:

  • Comparison of how much of the business was financed through debt and how much was financed through equity. For this calculation it is common practice to include loans from owners in equity rather than in debt.
  • The higher the ratio, the greater the risk to a present or future creditor.
  • Look for a debt to equity ratio in the range of 1:1 to 4:1
  • Most lenders have credit guidelines and limits for the debt to equity ratio (2:1 is a commonly used limit for small business loans).
  • Too much debt can put your business at risk… but too little debt may mean you are not realizing the full potential of your business — and may actually hurt your overall profitability. This is particularly true for larger companies where shareholders want a higher reward (dividend rate) than lenders (interest rate). If you think that you might be in this situation, talk to your accountant or financial advisor.

Debt coverage ratio

Definition: Indicates how well your cash flow covers debt and the capacity of the business to take on additional debt.

Formula: 

Net Profit + Non-cash expenses                                      Debt

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