4 Categories of Financial Ratios Every Business Owners Must Learn
Business owners need to evaluate their performance to know if they’ve reached their goals or not. Furthermore, they also need to know how they can take their business to the next level. Financial statements are one way to learn about the current status and performance of the company.
Additionally, the data from these reports can be further analyzed to reveal relationships. These can be done using financial ratios. Through these ratios, we can find connections between accounts that could indicate how well or bad the business is doing.
Financial ratios are very important as financial management tools. They reveal how much free cash you have, or tell if your current capital strategy is working as planned. You can use financial ratios to compare this year’s performance with that of last year’s. Additionally, you can also use it to see if your performance is level with that of your competitors and the industry.
There are four categories of financial ratios that business owners must know and understand.
1. Liquidity Ratios
Companies sometimes make credits. These happen either through trade or by borrowing money to fund operations or new projects. No matter the reasons, it is normal for companies to have debts.
What you need to know is if you can readily pay upcoming dues. This is what liquidity ratios are for. These ratios are used to know if the company can pay its short term debts without needing outside funding. These are different from solvency ratios, which determines the ability to pay long-term debts.
These ratios will tell how much cash can you make available at short notice. Knowing your liquidity is important to know if you will be able to operate in emergencies. Ratios under this category include the current ratio, quick ratio, and working capital ratio.
2. Leverage Ratios
Companies rely on both debt and equity to fund business operations. And financial management tells us that companies should use the right mix of equity and debt to improve the owner’s wealth.
With this, the liquidity ratios show how much of the fund comes from debt. Additionally, it also tells the ability of the company to pay off its debts. These ratios will help you see if your current debt and equity mix are working to your advantage or not. Further, knowing about them will also help you plan out the best funding plan for your business.
The most common ratios under this category are the debt-equity ratio, degree of financial leverage, and equity multiplier.
3. Profitability Ratios
These ratios evaluate the company’s ability to make earnings. Additionally, these ratios can also tell how much of the profit is made by savings in operating costs, or the use of assets.
Higher ratios are preferred. However, these ratios make more sense if compared with benchmarks. For example, you can compare your current profitability with the computed ratio from prior years. Further, you can also compare your ratios with those of the industry and your competitors.
This way, you can assess if you are doing well based on industry standards and see if you are doing better than other companies. With these ratios, you can set your plans to improve.
4. Operations Ratios
These ratios measure the company’s efficiency in managing its activities. It tells if your company is operating well or not. Specifically, these ratios mark how effective the company is in working its assets and liabilities.
Examples under this category include receivables turnover, average collection time, average days payable, and inventory turnover. Values for these ratios are results of good or bad operation practices and rules.
Expert Insights to Company Performance
Learning and understanding financial ratios are important to see in detail the results of company activities. However, we also understand that learning these formulas is hard and confusing learning on your own. In situations of urgent need, it is more convenient to have experts handle the job.
Are you looking for experts to give you insights about your company’s numbers? 3E Accounting has got that for you. We are a reputed accounting firm in the Philippines specializing in financial advisory services. Contact our expert teams today to understand more about your company performance.