Accounting – 5 Most Important Financial Ratios
Calculation of financial ratios is enough to curl most entrepreneurs’ hair, but you can’t avoid it if you want to analyze your company financial position. In fact, understanding and applying some financial ratios will help you to make informed business decisions (Also see 4 Tips for Analyzing an Income Statement). Here are the five most important financial ratios for your business.
The current ratio
The current ratio estimates your company’s ability to pay its short-term obligations. It is also known as liquidity ratio, cash ratio, or cash-asset ratio. A higher liquidity ratio implies that your business can effectively pay back its debts.
To calculate the current ratio, you will need to know the value of your current liabilities and current assets.
Current ratio = Current assets / Current liabilities
This ratio quantifies your business financial leverage and is estimated by dividing your company’s total liabilities by the shareholder’s equity. Note that the debt-to-equity ratio reveals the proportion of equity that your company uses to finance its assets.
Debt-to-equity ratio = Total liabilities/ shareholders’ equity
The acid test ratio
The acid test ratio is also known as the quick ratio. It is a gauge of the short-term liquidity of your business. Liquidity is a measure of the ability of your business to pay its debts as and when they fall due. The acid test ratio helps you to measure your business’s short-term debts and its most liquid assets.
Quick Ratio = (Current Assets – Inventory)/Current Liabilities
Net profit margin
The net profit margin (Also see How To Determine Profit Margins On Services) can help you to determine if your business is efficient at its cost control. Keep in mind that a higher net profit margin indicates that your business is more efficient in converting its revenue to real profits.
You should never assume that revenue is the same as profit (Also see 3 Common Accounting Mistakes that Most Business Owners Make). Revenue is the total funds that your business receives from clients who pay for products, while profit is what remains after your business has paid all its expenses and the cost of goods sold.
Net profit margin = Net profits/Net sales.
Return on Equity
Return on equity is a measure of your business profitability that determines the amount of profit your business generates with the shareholder’s equity.
Return on equity = Net income/Shareholders equity.
For you to clearly know what various financial statements say about your business, you must calculate these financial ratios. If you are not sure of how to calculate the financial ratios, engage an accounting service in Singapore and the experts help you. Otherwise, you will make wrong calculations and make the wrong financial decision based on wrong data.