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Financial ratios are important because they give business owners a way to evaluate the financial performance of their business.
Have you just started your own business or startup ? Or a seasoned entreprenuer you want to aid in the expansion of your company? In any scenario, maintaining track of financial ratios will help you analyze your company's financial situation and inform your business decisions.
Undoubtedly, there are dozens or maybe hundreds of potential financial statistics to keep an eye on. So which ones are the most important to you? This blog will help you make a decision.
Financial ratios are important because they allow business owners or founders to evaluate their organization's financial performance independently of its financial statements and in comparison to other organisations in the same industry.
Your Balance sheet, Income statement, and cash flow statement only offer a limited amount of information. Financial ratios go beyond simple statistical analysis to show how well your company gets cash, makes money, grows through sales, and manages costs. They can also act as a warning sign when something is wrong, letting managers and founders know when to make changes.
There are many financial ratios that can be monitored, but the most important ones fall into one of four categories:
Liquidity refers to your company's capacity to cover short-term obligations like accounts payable, accrued expenses, and short-term debt. A company may struggle to pay its creditors, suppliers, and other regular operating expenses when it has liquidity problems, which can lead to major problems.
Liquidity ratios often compare the firm's current liabilities and current assets (cash, inventory, and receivables).
Your capacity to pay short-term commitments, such as liabilities and debts due within a year, is estimated by your current ratio, sometimes referred to as your working capital ratio. As long as you have enough current assets on hand to pay all of your bills, accrued expenses, and short-term loans, your current ratio should ideally be higher than one.
For example, if a company has current assets of INR 50,000 (excluding inventory) and current liabilities of INR 25,000, their Current ratio would be 2.
Current Ratio = Current Assets / Current Liabilities
Quick ratio, also referred as your acid test ratio, serves as a similar indicator to your current ratio of your company's capacity to pay its debts. However, rather of considering all current assets, it solely considers the company's most liquid assets (cash, marketable securities, and accounts receivable). Prepaid expenses are excluded because you cannot use them to settle other short-term obligations, and inventory is excluded because it might take too long to convert it to cash.
For example, if a company has current assets of INR 50,000 (excluding inventory) and current liabilities of INR 25,000, their quick ratio would be 2.
Quick Ratio= (Cash & Cash Equivalents + Marketable Securities + Accounts Receivable) / Current Liabilities
Days working capital indicates the number of days required to convert your working capital into sales. A high score for days' working capital indicates that it takes your business longer to turn its working capital into cash. Because they utilize working capital effectively, businesses with smaller days' working capital require less funding.
For example, if a company's working capital is INR 50,000, and it's average daily COGS and expenses are INR 5,000, the company's Days of Working Capital would be 10 days.
Days Working Capital = ((Current Assets - Current Liabilities) x 365) / Revenue from Sales
Leverage is the total amount of shareholders' stock and debt in your company's capital structure. If a company has more debt than its peer for its industry, such company is said to be highly leveraged.
Having a high level of leverage is not always a bad thing. Low interest rates on loans could be leveraged by a growing company to seize market opportunities. Being heavily indebted could be a smart business decision, if the company can afford to make loan payments regularly. However, companies who struggle to make their payments may fall and unable to money in future to continue operations.
To assess how risky the company's financial structure is, your debt to equity ratio compares total debt to total equity. This statistic is closely watched by lenders and other creditors because it might indicate when businesses are taking on too much debt and may have problems making payments. A higher ratio indicates that a company is more leveraged, and may be at a higher risk of default.
For example, if a company has total liabilities of INR 50,000 and shareholder equity of INR 100,000, their debt-to-equity ratio would be 0.5.
Debt to Equity Ratio = (Long-Term Debt + Short Term Debt + Leases) / Shareholders’ Equity
Debt to Total Asset Ratio measures a company's leverage in relation to its assets. It helps to understand company's percentage of assets that are financed by creditors is indicated by your debt to total assets ratio. A higher ratio indicates that a company is more leveraged and may be at a higher risk of default. For example, if a company has total current liabilities of INR 50,000 and total current assets of INR 100,000, their debt-to-assets ratio would be 0.5.
Debt to Total Assets = Total Debt / Total Assets
Profitability ratios evaluate your ability to generate income (profit) and create value for investors or shareholders.
Your net profit margin ratio calculates how much net income your business makes for every rupees in sales. In other words, it displays the percentage of sales that remain after all costs have been covered by the company. A decent Net profit margin ratio varies by business, thus using a database of profit margins by industry, to compare your performance to that of your rivals is beneficial.
For example, if a company has a revenue of INR 100,000 and net income of INR 10,000, their net profit margin would be 10%.
Net Profit Margin Ratio = Net Income / Net Sales
By comparing your profits to the money you spent on assets, return on assets (ROA) shows how well your business is doing. A higher ROA indicates that a company is generating more profit for every dollar of assets.
While comparing your ROA to other businesses in your sector is useful, tracking your return on assets over time is more insightful. The general rule is that if this statistic increases from year to year, you're getting more profits out of each rupee of assets on the balance sheet. However, if your ROA is decreasing, it can indicate that you made some poor business decisions.
For example, if a company has net income of INR 10,000 and total assets of INR 100,000, their ROA would be 10%.
Return on Assets = Net Income / Average Total Assets
Your company's ability to turn a profit from shareholder investments into the business is gauged by your return on equity (ROE). A higher ROE indicates that a company is generating more profit for every dollar of equity invested.
For example, if a company has net income of INR 10,000 and shareholder equity of INR 50,000, their ROE would be 20%.
Return on Equity = Net Income / Shareholders’ Equity
Asset management ratios examine how effectively a business generates sales using its assets. Businesses that carry inventory or sell to clients on credit are often the only ones that employ the following ratios.
How effectively you handle inventory is indicated by your inventory turnover ratio. A high inventory turnover ratio indicates that a company is efficiently selling its products, while a low ratio may indicate that a company is struggling to sell its products or is carrying excessive inventory.
Compare your ratio to other organizations in your industry when assessing your inventory turnover ratio. Indicators of poor sales or excess inventory include a low inventory turnover ratio relative to the industry norm.
For example, if a company has COGS of INR 500,000 and an average inventory of INR 100,000, their inventory turnover ratio would be 5
Inventory Turnover Ratio = Cost of Goods Sold / Average Inventory
Receivables turnover helps to understand how quickly you recover credit sales. A high receivables turnover ratio indicates that a company is efficiently collecting payments from its customers, while a low ratio may indicate that a company is having difficulty collecting payments or is carrying excessive accounts receivable.
Comparing your Key metrics to your organization's credit standards and payment terms will help you determine whether your receivables turnover ratio is excellent or poor. If, for instance, your credit terms require customers to pay invoices within 30 calendar days but your receivables turnover reveals that it takes, on average, 45 days to collect payments, you may need to tighten up your collection procedures or have trouble extending credit to customers who are unable to pay.
For example, if a company has annual net credit sales of INR 500,000 and an average accounts receivable of INR 100,000, their receivables turnover ratio would be 5.
Receivables Turnover = Net Annual Credit Sales / Average Accounts Receivable
Q: What are Financial Ratios?
A: Financial ratios are a tool for analysing a company's financial statements, such as the balance sheet and income statement, in order to gain insight into its liquidity, profitability, efficiency, and solvency.
Q: Why Financial Ratios are important for Startups?
A: Financial ratios can provide important insights into a startup's financial health, allowing founders to make informed decisions about how to improve business operations and achieve financial success.
Q: Can you give me some examples of financial ratios that startup founders should be aware of?
A: Some financial ratios that startup founders should keep an eye on are gross margin, net profit margin, current ratio, quick ratio, return on equity, return on assets, debt-to-equity ratio, debt-to-assets ratio, working capital, and days of operation.
Q: How often should startup founders monitor financial ratios?
A: It's recommended that startup founders monitor financial ratios on a monthly basis or on quarterly basis to stay up-to-date on the financial health of their company.
Q: How to calculate financial ratios?
A: Financial ratios can be calculated by using financial data from a company's financial statements. The specific formula for each ratio will vary.
At Jordensky, we specialize in accounting, taxes, MIS, and CFO services for Startups and growing business and are focused on delivering an experience of unparalleled quality. When you work with Jordensky, you get a team of finance experts who take the finance work off your plate – ”so you can focus on your business.”
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