14 Types of Financial Ratios New Entrepreneurs Should Know About | CloudCfo
14 Types of Financial Ratios New Entrepreneurs Should Know About

14 Types of Financial Ratios New Entrepreneurs Should Know About

Posted on June 8, 2022
6 mins read

Running a business is a full-time commitment that requires strategic reevaluation and hefty planning. Since your company is still in its startup stage, it’s crucial to study up and plan ahead to stay on top of your competition and increase your market reach. 

While there are multiple ways to elevate your business, growth starts from continuously assessing your company’s health and identifying opportunities for improvement.

Fortunately, financial ratios can do just that! 

If you’re on the lookout for how you can propel your company forward through applying and understanding financial ratios, this article can be of great help.

What are Financial Ratios and Why Do They Matter?

Financial ratios help entrepreneurs assess their business’s performance, as they can use these figures as benchmarks to compare their brand with competition in the industry. It measures two or more statements on your financial reports, such as the balance sheet, cash flow, and income statement. 

While measuring financial ratios is not an easy task, it yields great advantages for your business. Apart from helping you track your performance, it also aids in spotting issues in your operations that can result in more serious problems in the long run. 

Moreover, financial ratios are commonly used to develop more helpful key performance indicators (KPIs) and account for project growth.

Understanding the Importance of Financial Data

Your business can generate financial data across everything you do. So, whether you want to focus on improving your sales, inventory, customer engagement, or even the company’s supplier terms, it’s possible by analyzing financial ratios.

However, you need to ensure that your company’s underlying data is available and accurate to successfully leverage this method. After all, using the right formula with the wrong variables would still result in incorrect and unreliable figures.

14 Financial Ratios You Can Use to Improve Your Business

There are multiple financial ratios you can use to measure the health of your business. In this article, we’ve curated 14 of the commonly used ones to help you get started.

By understanding these types of financial ratios, you can develop more appealing results for investors, differentiate yourself from the competition, and benchmark your performance.

Liquidity ratios

Liquidity metrics estimate the ability of your firm to pay back its liabilities using data from the statement of cash flows and the balance sheet.

  1. Working capital ratio

The working capital ratio, also known as the current ratio, is effective in helping you determine whether your business can meet short-term obligations or otherwise. It covers your existing assets such as cash, short-term investments, and inventories.

How to Calculate: Working capital ratio = current assets/current liabilities

  1. Quick ratio

Rather than dividing all existing assets by current liabilities, the quick ratio only evaluates your company’s liquid assets. It excludes prepaid expenses and inventory because you can’t use them to pay short-term liabilities.

How to Calculate: Quick ratio = (current assets – inventory – prepaid expenses)/current liabilities

  1. Cash ratio

The cash ratio considers cash and cash equivalents that are convertible within 90 days. Contrary to the quick ratio, your cash ratio is a better measure of your current financial health

How to Calculate: Cash ratio = cash and cash equivalents/current liabilities

Profitability ratios

Profitability ratios estimate how much income your business can earn after accounting for fixed costs such as operating expenses, tax, and debt.

  1. Gross profit margin

When assessing how much money your company is making as a percentage of sales, the gross profit margin compares your profits to the cost of goods. A higher margin implies that your business maximizes its profit and minimizes its expenses.

How to Calculate: Gross profit margin = net sales – the cost of goods or services sold/net sales X 100

  1. Net profit margin

The net profit margin determines if your business and its earnings per offering are profitable when compared to sales. Often, investors review this ratio because it reflects how successful a company can manage costs and turn revenue into profits.

How to Calculate: Net profit margin = net profit/sales X 100

  1. Operating profit margin

Operating margin focuses on the allocation of your expenses. A higher margin in this regard may imply that your company’s management and cost controls are improving.

How to Calculate: Operating profit margin = (gross profit – operating expenses)/revenue X 100

  1. Return on equity

The return on equity calculates the after-tax rate return on a shareholder’s investment. It measures how good or bad your management team handled and used its capital and resources.

How to Calculate: Return on equity = net profit/shareholder’s equity

Efficiency ratios

Efficiency ratios study your business’s core internal activities through the income statement and balance sheet. Usually, these are computed over a 3-5 year span.

  1. Revenue per employee

The revenue per employee ratio analyzes how efficient and productive your employees are. It also shows how your business manages its workforce compared to similar companies within the industry.

How to Calculate: Revenue per employee = annual revenue/average number of employees in the same year

  1. Inventory turnover

The inventory turnover ratio examines your company’s efficiency in replenishing its inventory. An increase in inventory turnover ratio indicates improved sales or an insufficient supply of products.

How to Calculate: Inventory turnover = cost of goods sold/average inventory

  1. Accounts receivable turnover

The accounts receivable turnover ratio estimates how well your business collects receivables or credit from your customers. A higher rate of this metric means your clients are paying on time and sufficiently.

How to Calculate: Accounts receivable turnover = net annual credit sales/average accounts receivable

  1. Average collection period

The average collection period allows your company to determine the length of time it takes your consumers to pay their invoices. It helps you ensure that you can pay your expenses on time and you would have sufficient sales to cover your operating costs.

How to Calculate: Average collection = 365 X accounts receivable turnover ratio/net credit sales

Leverage ratios

Also called solvency ratios, leverage ratios help evaluate your company’s debt and capacity to fulfill long-term obligations. Often, these are based on the balance sheet.

  1. Debt to equity ratio

Businesses that take on multiple high-interest loans increase their financial risk. The debt to equity ratio assists in determining your debt capacity and if you will be able to repay loans on time.

How to Calculate: Debt to equity ratio = total liabilities/shareholder’s equity

  1. Debt to asset ratio

The debt-to-asset ratio compares the assets of your company to its debt. Getting a high figure using this formula signifies financial insecurity because most of your assets come from liabilities.

How to Calculate: Debt to asset ratio = total liabilities/total assets

  1. Interest coverage ratio

The interest coverage ratio focuses on interest due based on your outstanding debt. Lenders would often compute this ratio to determine your company’s risk for future loans.

How to Calculate: Operating income / Interest expenses

The Road to Financial Health

Financial ratios can grow your business and keep its financial health stable if accurately calculated. These data can prove to your investors that your profits are solid, encouraging them to fund your expansion.

However, evaluating one’s company cannot be done using one ratio alone. Having a professional take over these financial tasks can give you a more comprehensive view of how your business is doing to make better-informed decisions as you grow your brand.

CloudCfo, a cloud accounting firm for startups and SMEs in the Philippines, can help you manage your ratio computations with their top-notch financial reporting service and other finance function offers that can help scale your business. Contact us today to jumpstart your business’s journey towards financial health!

DISCLAIMER: This article is strictly for general information purposes only. Nothing in this article constitutes or intends to constitute financial, accounting, regulatory or legal advice and must not be used as a substitute for professional advice. It is still necessary to consult your relevant professional adviser regarding any specific matter referenced above.

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Get In Touch

If you want to know more about our tailored services and processes, drop us a line to discuss how we can help you to grow your business. We will respond to you within 24 hours.