Financial ratios are simply formulas, which describe a simple mathematical calculation – written as a mathematical equation. They are often used in business as a way of measuring the business viability, health and profitability.
These ratios can be also set as KPIs (Key Performance Indicators) and they can tell the story of your business without having the need to use any words at all.
When bookkeeping is maintained properly, and all financial transaction are recorded in the right place, the business financial reports will provide you with critical facts about the business performance, including even a business projection.
There are several occasions where financial ratios might be used, including:
- A bank lender assessing your request for a loan
- A business investor contemplating weather they should buy shares in a business
- A business owner, trying to set some goals for the next coming year
- An asset valuation from a Gov / Federal entity
Whatever reason it may be, financial ratios can help us understand our business finance better and drive our efforts towards success.
Which type of financial ratios are commonly used?
There are many different types of financial ratios. It is a common practice to sort these ratios into 4 different categories:
- Profitability ratios
- Efficiency ratios
- Leverage ratios
- Liquidity ratios
Profitability ratios are often used as in any type of business and they also help you to understand whether you are performing well in the industry you operate.
When a business is up and running for several years, Profitability ratios might help you to analyse your profitability by reviewing previous years as well.
Let’s take couple of simple examples and apply the use of ratios to see how we can really use it in our daily life.
NET PROFIT MARGIN RATIO
The NET PROFIT MARGIN is a simple ratio which indicates your business profitability.
It described the relationship between your Net income (after deducting tax) your overall revenue from sales.
Here is the formula of this ratio:
Net profit / Total revenue
It indicates in % how much money you actually get from each $ you earn. The higher the % is the better your business perform.
It also helps you to reflect on your numbers when comparing your own business to other businesses in the industry you work in.
You can also use this ratio when preparing budget for the next year, to see where costs for example can be deducted, to increase your profitability.
Efficiency ratios are often used as in any type of business and they also help you to understand whether you are managing efficiently different processes in your business.
It can indicate your efficiency in sales, stock management and control, ordering systems, customer satisfaction and much more.
INVENTORY TURNOVER RATIO
The INVENTORY TURNOVER is a simple ratio which indicates your business efficiency.
It indicates the efficiency of your inventory management, by showing how well your business is in turning over its inventory within a period of time.
Here is the formula of this ratio:
Cost of goods sold ($)/ Average Inventory($)
The result shows the number of times a stock is being replaced over a period. It will indicate how one business manages costs and how effective their sales strategy is.
For instance, say we have 2 retails selling T shirts and we want to buy one of them.
Looking at how much stock they hold on average during a year and looking of the actual cost of the goods ( T shirts) we can simply calculate the Inventory Turnover ration to see which one gives us better result.
Low numbers can indicate poor sales or too much stock ordered, while high numbers indicate high efficiency in turning over stock, increased traffic and good ordering management system.
You do not have to be an accountant to understand or use financial ratios, and there many other ratios which can be used to measure other things we mentioned above.
However, it is always best practice to use a specialist before making any crucial business decision.
Study Business and Marketing with us!