How to Analyzing the Financial Health of Your Business?
It is never too early to assess how your business is doing, from a financial point of view. Many entrepreneurs may fear this type of analysis but a smart entrepreneur looks at a situation and determines how best it can be turned around as soon as there are signs of problems.
The following section outlines some financial ratios you can use to compare your situation to industry standard ratios, to see how you are doing.
Current Ratio = Current Assets / Current Liabilities
The current ratio calculation tells you if you have enough liquid assets compared to your current liabilities
Current Assets are things that you can dispose of within a year.
Current Liabilities are debts that are short term, payable within one year.
Accrued Expenses Payable (salary, wages, interest on bank loans, taxes, etc.)
The figures come from your balance sheet. The general benchmark is for your current ratio to be greater than two. This means that you have twice the current assets to cover your current liabilities. If your current ratio falls below one, you are in serious financial danger.
You can check to see what the current ratio standards are for your particular industry by asking a banker, accountant, or by checking key financial ratios that are published by several companies, (e.g. Dun & Bradstreet, Moody’s, Standard & Poor’s).
“Sales are the key to all business. Whatever else is going on in your business, never take your eyes off sales.” Ron Connelly, Connelly Group of Companies
Quick Ratio = (Cash + Receivables) / Current Liabilities
This ratio is sometimes called the acid test because it includes only those assets that are easy to turn into cash fast.
The general benchmark is to keep your quick ratio above 1.0.
Each industry has different suggested “safety nets”. Take the time to investigate yours.
Debt-to-Equity Ratio = Total Liabilities / Total Equity
This is a critical ratio for anyone considering lending you money.
Lenders like to see a low debt to equity ratio. Generally the ratio should be 1:1 to 3:1.
Equity investors like to see a high ratio, because it increases their leverage in the business.
Use the balance sheet for these figures.
Check industry averages to see how your company compares.
The following ratios will become important as your business grows. Use them to assess whether the profits you are making are equal to the risks you are taking. This is also the type of information that investors look at when considering your company’s potential.
Efficiency and Performance Ratios
Inventory Turnover = Cost of Goods Sold / Average (Beginning + End Inventory / 2)
This ratio tells you how fast you sell your inventory. This is important to know because your money is invested in your inventory. You need to assess whether you are selling enough inventory in a short enough period of time.
Use the balance sheet for your inventory numbers.
Use your income statement for the cost of goods sold.
The ratio will tell you how many times in a year you turn over your inventory. Divide that number into 365 days (1 year) and you can determine how many days it takes to turn over your inventory.
You must look at industry standards to assess whether your inventory turnover ratio is good or bad. It will also change, depending on the time of year.
Receivables Turnover = Sales on Credit / Average Accounts Receivable (Beginning + Ending Balances / 2)
This ratio helps you determine how long it is taking for you to collect money owed to you (accounts receivables) and lets you compare it to your collection policy.
You must calculate the percentage of total sales you make on credit.
You can use the accounts receivable from your balance sheet.
The ratio will give you the number of times per year you turn over your receivables.
Take this number and divide it into 365 (1 year) to determine the average amount of days it takes to turn over your receivables.
Compare this number to your company policy (30, 60, 90 days) to see if your customers are paying you on time. If not, you must re-evaluate your collection policy or withhold credit from chronic abusers.
Net Profit Margin = Net Profit / Gross Revenue on Sales
Compare this ratio from one year to the next.
Use your income statement for these figures.
Return on Investment = Net Profit / Total Assets
This ratio is commonly used as a measure of a company’s profitability.
Use the figures from your balance sheet and income statement for these calculations.
Compare your figures to those in your industry.
Return on Equity = Net Profit / Owner’s Equity
This ratio gives you the return on the equity part of the investment.
Use the balance sheet and income statement for these figures.
This ratio can help you determine if you business should be more or less leveraged (in debt) to maximize the return on investment.