No matter where your expertise lies, when running a business, you ought to know how to read your financial statements and make business sense out of them. The three financial statements – income statement, balance sheet, and cash flow statement – can tell you a lot about the financial health of your business. Club it with accounting ratios, and you can compare your financial health with that of any company, irrespective of its size.

What are Accounting Ratios?

Accounting ratios compare an outcome with the base to determine and assess a company’s liquidity, leverage, growth, margins, profitability, rates of return, and more. For instance, a net profit of $55,000 is an absolute number. But when you convert it into a ratio of net profit margin (Net profit/revenue), it tells you how much profit (outcome) you earned on your revenue (base). Suppose your net margin is 15%. You can now compare this margin with your preceding year’s margins and see if your profit grew faster/slower than revenue. A business that improved its net margin from 12% last year to 15% this year signifies the outcome of a business owner’s efforts to improve profitability.

You can prioritize some crucial ratios to your business, which will help you make informed decisions. For instance, companies with high debt and struggling to meet their debt obligations can focus on leverage ratios. Retailers of perishable goods for whom timely sale of inventory is essential can focus on inventory turnover.

You can even set a target range for such ratios crucial to your business and monitor your financial statements to ensure the ratios hover within this range. Let’s see how to use some of the most common accounting ratios to make business sense.

Profitability ratios

As the name suggests, profitability ratios measure how much profit you generate from your business operations. You can even measure the profitability ratio with competitors and the industry average to understand if your business is doing well.

You can measure profits From your income statement as a revenue percentage.

• Gross margin = Gross Profit/ Revenue
• Operating margin = Operating Profit/ Revenue
• Net margin = Net Profit/ Revenue

Each of these ratios tells you where the cost efficiency lies. A manufacturing company’s gross margin will be significant as most of its cost goes into making the product. A service company will focus on operating margins as their most considerable expense is employee salaries. Any new product, market expansion, merger or acquisition is done with the intent to improve margins.

A company might look at the gross margin of all its products and create a product mix that helps it improve its gross margin. If there is a considerable gap in the operating and net margins, the company might focus on reducing interest costs on debt or non-operating expenses to improve net margins.

You can also measure the return on investment for different projects to select the ones that generate higher profits.

• Return on assets (ROA) = Net Income/Average Total Assets
• Return on capital employed (ROCE) = Net Income/Average Capital Employed
• Return on Equity (ROE) = Net Income/Average Equity Capital

These ratios measure the asset’s ability to generate income. Suppose you decide between buying or renting machinery; you can look at its ROA. If you are taking a loan to buy the machine, the ROA should be higher than the interest paid on the loan.

Similarly, when you approach an investor, they might consider your business ROE to determine whether to invest or how much to invest.

Liquidity ratios

These ratios are essential for managing business cash flows and ensuring sufficient cash and assets to meet obligations to lenders and vendors. They are vital for companies with high working capital requirements, such as subprime lenders, who might need them to balance receivables and payables.

To calculate liquidity ratios, you need:

Current assets include inventory, cash, prepaid expenses, investments and accounts receivables due in 12 months.

Current liabilities include accounts payable, loan amount, taxes payable due in 12 months, and any customer advances.

• Current ratio = Current Assets/ Current Liabilities
• Quick ratio = Quick Assets (Accounts Receivables + Cash)/ Current Liabilities

This ratio tells you if your current assets are sufficient to meet current liabilities. A ratio below 1 hint that you need to arrange for working capital as there are insufficient funds.

Inventory may be hard to sell, or receivables may not be a good option as clients are delaying payments. Such scenarios are common during economic uncertainty. At such times, companies increase their cash reserves to sustain business. Cash ratios can tell if you have enough cash to meet your obligations.

• Cash ratio = Cash/Current Liabilities
• Cash coverage ratio = Earnings before interest and taxes, depreciation/interest

A cash ratio of 2 states that you have twice the cash to cover current liabilities, hinting that your business is in a good financial state.

​Efficiency Ratios

These ratios largely focus on sales to determine if your assets or inventory are generating enough sales. If you sell products on a credit basis, it will tell you how quickly you collect the money.

• Inventory turnover ratio = Costs of goods sold/Average Inventories
• Assets turnover ratio = Sales/Average Total Assets
• Accounts receivable turnover ratio = Sales/Average Accounts Receivable
• Accounts payable turnover ratio = Total Supplier Purchases/ Average Accounts Payable

Suppose your inventory turnover is 4. This means that you replenish your inventory 4 times a year. You can convert this into several days using the formula (365/Inventory Turnover). In our example, number of inventory days is 91 (365/4), which means it takes an average of 91 days to sell your inventory. This information can help you place your orders with the vendor accordingly.

If inventory days increase, you know that the goods in your inventory are not selling, maybe due to low demand or product or distribution issues. So you can probably order products that sell fast.

You can also do a similar analysis for the remaining ratios, depending on your business type.

Contact Edelkoort Smethurst CPAs LLP in Burlington to Help You Analyze Business Accounts

There are many such ratios, like leverage ratios and expense ratios. A professional accountant uses these ratios to help you analyze your financial statements and highlight concerns or opportunities for timely decisions. At Edelkoort Smethurst CPAs LLP, our accountants and bookkeepers can provide services such as preparing and analyzing financial statements. To learn more about how Edelkoort Smethurst CPAs LLP can provide you with the best accounting and bookkeeping expertise, contact us online or by telephone at 905-517-2297.