When planning to sell your business or grow it with the involvement of investors or lenders, there are ways to measure its financial health using a variety of ratios and better manage your company. These various ratios are key performance indicators (KPIs) that can help you stay up to date on the current health of your business, increase value, and gain a competitive advantage.
Working Capital Ratio
The working capital ratio, also known as the cash ratio, is a valuable way to measure your company's liquidity, which essentially shows how easily the business's assets can be converted to cash. This measurement indicates a company's capacity to pay off current liabilities with its existing assets. The formula compares current assets to current liabilities:
Working Capital Ratio = Current Assets (÷) Current Liabilities
For example, if a business has current assets of $10 million and current liabilities of $5 million, the working capital ratio is 2 ($10 million/$5 million), indicating healthy short-term liquidity. A lower ratio could indicate problems with liquidity, even if only temporary. A higher ratio usually means a company has healthy liquidity, but it can also be a sign that it has too much in short-term assets that could be invested more prudently.
The debt-to-equity (D/E) ratio calculates how much a business is financing its operations using money that is borrowed. It can be used to determine if your company is borrowing too much and if you can cover the debt you have accrued. Too much debt can raise fixed charges, lower the amount of money for dividends, and create shareholder risk. The D/E ratio is often used to compare different companies within the same sector to assess the lower-risk venture. The formula is as follows:
D/E Ratio = Total Liabilities (÷) Total Shareholder Equity
This formula shows the percentage of a company's assets that creditors finance. A high ratio means there is a significant dependence on debt, and it could signal financial weakness.
Debt-to-Asset Ratio (=) Total liabilities (÷) Total assets
The quick ratio also measures liquidity by assessing the business's ability to pay current liabilities with assets that can be quickly converted to cash. The ratio's formula is:
Quick Ratio = Current Assets (-) Inventory (-) Prepaid Expenses (÷) Current Liabilities.
Inventory is subtracted in the formula because it takes time to sell and convert inventory into liquid assets, which is counter to the basic idea behind the quick ratio. A quick positive ratio means the business has enough cash to pay bills and continue operating. If the quick ratio is lower than one (1), it could mean that the company does not have enough in liquid assets to pay short-term liabilities. The situation may only be temporary, but raising more capital would be a solution.
Net Profit Margin Ratio
This ratio is the percentage of your company's revenue that is left after deducting all of its operating expenses, interest, and taxes. Net profit margin shows how well a company manages costs and converts revenue into profits. The formula is:
Net Profit Margin (=) Total Revenue (-) Total Expenses
A poor net profit margin can signal problems, such as declining sales or poor customer service. On the other hand, a high net profit margin means that you are pricing your products appropriately and doing an excellent job of controlling costs.
Gross Margin Ratio
This ratio is especially relevant if your company sells products. First, you need to know how much money you have left to pay for your operating expenses after paying for the creation or procurement of products you sell. The formula for this ratio is:
Gross Margin Ratio (=) Sales (-) Cost of Goods Sold
A high gross margin means you have more money to pay for other necessary business expenses. Conversely, a low gross margin means you could struggle to cover your operating expenses.
Earnings Per Share (EPS) Ratio
The earnings per share (EPS) ratio assesses a company's profitability and value. A higher EPS translates to greater value. The EPS ratio formula is:
EPS (=) Net Income (÷) Weighted Average Number of Common Shares Outstanding That Year
Price-Earnings (P/E) Ratio
Investors use this ratio to determine a company's stock's potential for growth. Basically, how much would investors pay to receive one dollar of earnings? In addition, it's commonly used to compare the potential value of more than one stock. The formula is as follows:
P/E Ratio (=) Company's Current Stock Price (÷) Earnings Per Share (EPS)
Return on Equity (ROE)
Return on equity (ROE) analyzes investment returns. It is a percentage that quantifies profitability and how well a business uses shareholder money to generate profits. The higher a company's ROE, the better it creates profits using shareholder equity. The formula for ROE is:
ROE (=) Net Income Before Paying Common Share Dividends and After Paying Preferred Share Dividends (÷) Total Shareholders' Equity
Accounts Receivable (A/R) Turnover
This ratio is also known as days sales outstanding (DSO). It measures how well your company is doing at getting paid once a sale has been made. The formula is:
A/R Turnover (=) Total A/R Outstanding (÷) Total Sales
Cash flow is especially important for most smaller and mid-sized businesses, so being paid promptly can make it much easier to pay bills. If your A/R turnover ratio is high, you need to make an effort to improve your receivables processes.
Inventory Turnover Ratio
This particular ratio is key for businesses that have inventory. It reveals how often inventory was converted to sales in a period of time, whether by month, quarter, or year. The formula for this ratio is:
Inventory Turnover Ratio (=) Cost of Goods Sold (÷) Average Inventory
A high inventory turnover ratio means your inventory is turning over frequently. This ratio can help reveal if resources are being wasted. In addition, investors use this ratio to assess how liquid a company's inventory is, and creditors use it since inventory is often used as collateral. If the inventory cannot be sold, it is not very worthy.
Why Ratios Matter
These financial ratios can help measure the financial health of your company. They can help you identify strengths and weaknesses, areas where you could make changes, and which improvements can ultimately improve your company's valuation before entering into a merger or acquisition or taking on new investors or lenders. They can also help you improve your position from the perspective of lenders. In most cases, the ratios can be most effective when comparing results over several periods. Ratios can also reveal trends in certain sectors, serving as benchmarks for measuring the performance of all players in that industry. Small businesses can use these benchmarks to see how they stack up to competitors in the same space, create organizational strategies to improve performance, and set time-based goals.
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