You can note and record your business performance using available data in quite a few ways. Using financial ratios, you can quickly assess all areas where your business performance is excelling or underachieving. This way, you can judge where you need to improve in the areas you lack and where you need to retain and maintain the areas you have had success.
Furthermore, the other motive for using financial ratios in your business is that you can see and decide just how beneficial or disadvantageous any such modifications will be in one area. You can also easily measure the effects of the changes elsewhere in another area.
The importance of monitoring figures closely in your business will help you minimize waste and maximize efficiency, which will, in return, grow and flourish your business over time.
Where do you get the information you need to calculate your financial ratios? Moreover, bookkeeping will help you provide all of the necessary and relevant information from which your accounts are formulated. The process of bookkeeping is recognized and well-defined in the field of business and accounting.
Every transaction, regardless of its nature (purchase or sale), has to be recorded. However, bookkeeping helps ensure accurate and timely records. Here are four ways to assess your business performance using financial ratios.
Current Ratio
The most regular and familiar ratio used is the current ratio. This ratio calculates the ratio of current assets to current liabilities. Moreover, it helps specify a company’s potential and capacity to pay off its short-term invoices and bills.
If the business has more liabilities than assets, the current ratio will be less than one. However, if the company has more assets than liabilities, the current ratio calculated will be more than one.
If a business’s current ratio is high, it indicates a safety cushion. If the business has more assets than liabilities, its flexibility will be increased. Furthermore, if the business has more liabilities than assets, it might have to convert its receivable balances and some inventory items into cash, which may not be easy.
Business can pay off their debts, collect their due receivables, purchase inventory only when required, and convert their short-term debts into long-term debts to improve their current ratio.
Liquidity Ratio
Liquidity ratios can be found in three types:
- The current ratio is calculated when the sum of the company’s assets is divided by their total current liabilities. However, this ratio measures if you have sufficient assets to pay for your liabilities. Additionally, if your current ratio is calculated to be two, you have twice as many current assets as your current liabilities.
- The quick or acid-test ratio is calculated by dividing current assets (not including stock) by the total current liabilities. Moreover, if your quick or acid-test ratio shows the result of one, it means your business’s liquidity levels are sufficiently high. However, this indicates that your business is in solid financial health.
- The defensive interval is calculated by dividing the total liquid assets by daily operating expenses. The ratio estimates how long you can survive your business without any cash flowing in. Usually, it is found to be between 30 and 90 days.
Solvency Ratio
Solvency ratios measure the financial stability of a business since they calculate a business’s debt concerning its equity and assets. Any company with too much debt might not have enough flexibility to manage its cash flows if the interest rates rise or the business conditions deteriorate.
The common solvency ratios calculated are debt-to-asset and debt-to-equity. The debt-to-asset ratio is found by dividing total debt by total assets. The debt-to-equity ratio is calculated by dividing total debt by shareholders‘ equity, which is calculated by calculating the difference between all total assets and liabilities.
Profitability Ratio
Profitability ratios calculate the management’s ability to change the amount of sales dollars earned to cash flow and profits. The net profit ratio can be used to evaluate your business’s profitability. Divide the total profit before tax by the net sales amount to determine your net profit.
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