Financial Ratios

Financial ratios provide you and your audience with an objective basis for comparing the performance of your business with other businesses in your industry. In addition, financial ratios also provide you with the tools necessary to assess whether certain operations of your business need fine-tuning. The following list explains how each of the financial ratios is calculated and what it tells you about your business's financial health. The list does not include all of the ratios that you or your accountant might calculate. However, it does include those financial ratios that should be included in your business plan. They provide a clear picture of your business's ability to generate a profit, pay its bills on a timely basis, and utilize its assets efficiently.

• Current Ratio = Current Assets / Current Liabilities

This ratio is the most commonly used measure of short-term solvency. It indicates the amount of current assets, such as cash, accounts receivable, and inventory, that can be converted into cash to pay your short-term liabilities.

• Quick Ratio = (Cash + Stocks & Bonds Held for Investment + Accounts Receivable) / Current Liabilities

This ratio is a variation of the Current Ratio. It looks at current assets, but only those that can be quickly converted into cash to meet short-term liabilities. Many lenders are interested in this ratio because it does not include inventory, which may or may not be easily converted into cash.

• Profit Margin Ratio = (Net Income + Interest Expense for the Period) / Revenues

This ratio provides a good indication of your business's ability to manage operating expenses at a given amount of revenues. For example, if your profit margin has been diminishing over consecutive periods and revenues have remained the same, you may want to take a close look at your operating expenses to see if you can cut overhead costs without affecting sales.

• Average Collection Days to Receivable Ratio =

Annualized Accounts Receivable / Annual Net Credit Sales

This ratio represents the average length of time it takes your business to convert credit sales into cash. It is calculated by multiplying your current accounts receivable by the number of days in the year. The result, annualized accounts receivable, is divided by your total annual credit sales. The resulting ratio shows the average number of days it takes to collect on receivables. A ratio that is high by industry standards will generally indicate that your business needs to improve its credit policies and collection procedures.

• Debt Ratio = Total Debt / Total Assets

This ratio indicates the amount of debt your business has taken on relative to the total assets it owns. A high debt ratio indicates that creditors have financed a substantial portion of your business. This is often a red flag to potential lenders since it increases the possibility of bankruptcy if your net sales are not enough to meet your monthly debt and interest payments.

• Return on Total Assets = Net Income / Total Operating Assets

This ratio indicates the rate of return being generated by the assets of your business. In some cases, consecutive periods of diminishing ratios may indicate a poor utilization of your plant and operating equipment. On the other hand, one or two periods of a lower ratio may not be cause for concern. In many instances, businesses gearing up for future growth invest in operating assets that do not immediately begin generating additional sales.