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| Wednesday, 05 October 2011 20:34 |
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Taylored Comments Ratio Analysis for Small Businesses by Lindsay Gleason, Consultant - Finance and AccountingThere are a variety of financial ratios that measure the health of a small business. Just as your Income Statement (P&L) and Balance Sheet measures the financial success of your company, so do financial ratios. Understanding these will help you analyze your financial statements. Lets look at 6 ratios that we use to determine the fiscal health of a company. Goals must be set for specific attainment of these ratios and they should be reviewed as often as Financial Statements (i.e. monthly): 1. Working Capital Ratio - also known as the Current Ratio: This ratio measures the company’s near term ability to pay its short term debt obligations due within the next year. It tends to measure the adequacy of working capital to operate the business as well as liquidity. Formula - Current Assets divided by Current Liabilities Goal - $2 of Current Assets to $1 of Current Liabilities
This is a much more stringent test of short-term liquidity. Quick assets include cash, short-term investments and accounts receivable (net of allowance for doubtful accounts). It is sometimes expressed as Current Assets – Prepaid Expense & Inventory, though inventory is sometimes included if it can be turned quickly. Formula - Quick Assets divided by Current Liabilities Goal – at least $1 of Quick Assets to $1 of Current Liabilities 3. Debt Ratio: This ratio shows what percentage of the firm’s assets is financed by debt. Generally, a lower ratio indicates less risk for the firm as the burden of debt repayment and interest is less. Formula - Total Debt divided by Total Assets Goal – 100% or less 4. Sales Days Outstanding: This measures the average number of days it took to convert accounts receivable into cash and indicates the effectiveness of credit and collection activities. The longer the timeframe used for this calculation, the more accurate it is. The lower the number of days, the faster A/R has been collected and cash has been treated as the king it indeed is. Formula - Average Accounts Receivable divided by Average Daily Sales Goal – Less than 35 days 5. Debt/Equity Ratio: The lower the percentage the better. This ratio shows what portion of the financing has been provided by creditors’ debt. For long term solvency and stability, enough financing needs to be provided by owners. If the owners do not have enough owners equity or “skin in the game” the business is in a riskier financial position. It is not uncommon for small business owners of “S” Corps and LLCs to remove too much of the profits from operations leaving the company heavily financed by debt. This is not just riskier for the firm but it also costs more to pay interest and be burdened by debt repayment than to use profits and owners investment to pay creditors. Formula - Total Liabilities divided by Owners Equity Goal – As close to 0% as possible 6. Annualized Return on Assets: Higher results are better. This ratio measures how effectively a firm generates profits with its available assets. Interest and depreciation expenses are ignored to remove the effects of financial leverage from borrowed funds on profit. Formula - Net Income plus Interest and Depreciation divided by Total Assets. Goal – 50% or better If you follow these ratios, your business will be stabile and viable. All of these ratios are part of the Roadmap to Profitability Financial Dashboard that is available for your use. More information about the dashboard and our Financial and Accounting Consulting Services can be seen by clicking on the appropriate tab of the TBG website. Or just call us at (816) 737-3681. Comments (0)
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