Lenders love to analyze ratios. It allows them to see how your business is doing and compare your business to other businesses theyve loaned money to. But ratio analysis is a useful tool for the business owner too.
How healthy is your business? Some basic ratio analysis will tell the story. Calculating these three financial ratios will let you check your businesss current temperature, diagnose potential problems, and see if your business is doing better or worse over time.
1) Current ratio
The current ratio is an excellent diagnostic tool as it measures whether or not your business has enough resources to pay its bills over the next 12 months. The formula is:
Current ratio = Current assets/Current liabilities
Recall that Current assets are a category of assets on the balance sheet that represent cash and assets that are expected to be converted into cash within one year.
Current liabilities are a category of liabilities on the balance sheet that represent financial obligations that are expected to be settled within one year.
For instance, suppose a business has $8,472 in current assets and $7200 in current liabilities. Then the current ratio is $8,472/$7200 = 1.18:1.
So for this business, the current ratio gives a clean bill of health. For every dollar in current liabilities, there is $1.18 in current assets.
A current ratio of over 1 is good news, generally, although if you are comparing your current ratio from year to year and it seems abnormally high, you may have problems with collecting accounts receivable or be carrying too much inventory.
2) Total debt ratio
The name of this ratio says it all; this ratio shows how much your business is in debt, making it an excellent way to check your businesss long-term solvency. The formula is:
Total debt ratio = Total debt/Total assets
Once again, you can take these numbers from your balance sheet and plug them in. For instance, a business with $22,375 in total assets and $25,000 in total debt would have a total debt ratio of $25,000/$22,375 = 1.11:1.
This business, then, has $1.11 dollars in debt for every dollar of assets. So for this business, the total debt ratio tells us that this business is not in good health and may become really ill; for good health, the total debt ratio should be 1 or less.
The lower the debt ratio, the less total debt the business has in comparison to its asset base. On the other hand, businesses with high total debt ratios are in danger of becoming insolvent and/or going bankrupt. (You can see why lenders take such an interest in this ratio.)
3) Profit margin
How much net profit are your businesss sales producing? Calculating the profit margin will give you the answer. The formula is:
Profit margin = Net income/Sales
For instance, if a businesss sales are $180, 980 while its net income is $42,325, its profit margin is $42,325/$180,980 = 23.4%.
So for every dollar in sales, this business is generating a little more than 23 cents net profit. How healthy is this? Other than the obvious generality that the higher the profit margin the better off the business, the profit margin is an extremely useful measure of how your business is performing over time. At a glance, you can see whether your businesss net profit has increased, stayed the same, or decreased over last year. And if its decreased, youll know to take steps to cure the problem, such as better controlling your expenses.
Imagine all three of the ratios in the examples above belonging to a single business, and you can see how just calculating these three ratios can provide a quick health check for your business. The business in the example isnt at deaths door yet but it is ailing. While the profit margin and current assets ratio are robust, the total debt ratio shows that the business is carrying too much debt, which will interfere with cash flow if it hasnt already.
How healthy is your business? Calculate these three ratios regularly to see how its faring.