Financial Ratio Analysis is one of the most invaluable activities that any business should do as part of their financial statement analysis. Results from this exercise will help your business make strategic business decisions that will help your business grow.
These ratios show your business’s ability to generate profit after expenses. Some common ratios that measure this are as follows:
Gross Profit Margin
To arrive at your gross profit margin you take your gross profit (Sales less Cost of Goods Sold) divided by the Sales.
Return On Assets (ROA)
This ratio is computed based on your net income divided by your average total assets. It shows you how much earnings your business is creating on the resources (assets) that your company invested in.
Return On Equity (ROE)
The ROE is similar to the ROA except that, you are comparing net income to the shareholders or owners equity.
These ratios are a measure of your business’s ability to pay off its short-term debts in the event that the business needs to liquidate its assets. To measure liquidity, you can look at the following ratios:
The current ratio divides your business’s current assets by the current liabilities. The higher the current ratio, the more likely that a business can pay off its short-term obligations.
Acid Test Ratio or Quick Ratio
The Acid Test ratio is similar to the current ratio but instead of using all the business assets it uses only the liquid or easy to convert to cash assets. The latter which include cash, short term investments and accounts receivables are often referred to as quick assets.
Inventory is excluded in this test because it generally takes longer to convert to cash compared to the other ‘quick assets’.
These ratios show how quickly you can turn your assets into income, and the most common are the following:
Asset Turnover Ratio
To know if your business is effectively using your assets to make revenue you can use the asset turnover ratio. This is computed by dividing your sales with your average total assets.
Inventory Turnover Ratio
This ratio is useful when you are selling inventory because you will want to know if your inventory is moving as it should. The ratio shows how often your goods are sold in a specified period.
If the ratio is low, it could mean that your cash is tied up in your inventory. To compute this ratio you take the cost of goods sold for the year divided by the average inventory in the same period.
The leverage ratios will show the ability of your business to pay off its debt.
Debt To Equity Ratio
This ratio compares your total debt to your total equity. A company may be funded by debt and investments from stockholders and comparing both with each other will show your total leverage.
Debt To Asset Ratio
The ratio shows the the percentage of total assets that is owed to creditors. To calculate it the total liabilities are divided by the assets.
Financial Ratios are an invaluable performance indicator for your business. If you would like a Financial Statement Analysis Report please contact us .