Key Financial Ratios You Should Know
Financial ratios are important because they give you, as a business owner, a way to evaluate financial performance beyond financial statements and compare it to similar businesses in your industry. By using ratios, you can gain insight into your company’s profitability, efficiency, liquidity, and solvency. Here are some key financial ratios you should know as a business owner.
Profit Margin Ratio
Profit Margin = (Total Revenue – Total expenses) / Total revenue
The profit margin ratio measures a company’s net income as a percentage of its revenue. It shows how efficiently a company is generating profits from its operations. A high profit margin indicates that the company is earning more profit per dollar of revenue, and a low profit margin may suggest that the company is struggling to generate profits.
Return on Assets (ROA)
Return on Assets = Net Income / Average Total Assets
A company’s return on assets measures how effectively a company is using its resources to generate profits. A high ROA indicates that a company is generating significant earnings from its assets, while a low ROA suggests that the company is not utilizing its assets effectively to generate profits.
Debt to Equity Ratio = (Long-Term Debt + Short Term Debt + Leases) / Shareholders’ Equity
The debt-to-equity ratio measures a company’s total debt relative to its shareholder equity. It shows how much of a company’s funding comes from debt versus equity. A high debt-to-equity ratio indicates that a company has more debt than equity, which can be a risk factor. However, companies with consistent cash flows might be able to sustain a higher ratio without running into problems.
Current Ratio = Current Assets / Current Liabilities
The current ratio, known as a working capital ratio, measures a company’s ability to pay its short-term debts with its short-term assets. It compares a company’s current assets, such as cash, inventory, and accounts receivable to its current liabilities, including accounts payable and short-term debt. A high current ratio indicates that a company has enough current assets to cover its short-term liabilities, while a low current ratio may indicate that the company may have trouble paying its debts.
Inventory Turnover Ratio
Inventory Turnover Ratio = Cost of Goods Sold / Average Inventory
The inventory turnover ratio indicates how quickly a company sells its inventory and replaces it with new stock. A high ratio suggests that a company is selling its inventory quickly, which is generally viewed positively, implying that the company is efficiently managing its inventory and generating sales. A low ratio indicates a company is holding too much inventory or has difficulty selling its products, which can lead to higher costs associated with inventory storage.
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