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Business ratio

Learn 3 simple business ratios to identify negative trends in your business in less time than it takes to read your favourite newspaper.

Business ratios are tools that help you in evaluating the current performance of your business.  They are also very effective in helping you detect problem areas within your business before they get out of hand.  Business ratios are mathematical relationships between different items in the financial statements.  They are quite simple to calculate and learn, but require that you have some basic knowledge about financial statements.  

Today we will discuss three different types of business ratios, although there many more types that are used in business analysis on a regular basis. 

 Liquidity ratios.  These types of ratios measure the ability of a business in meeting its short-term obligations.  One major business ratio under this category is the current ratio, calculated as follows:   

Current ratio = Total Current Assets / Total Current Liabilities 

The higher the current ratio, the more capable the business is in meeting its short-term obligations.  A current ratio which is lower than 1 usually indicates that the business is not able to meet its short-term obligations when they fall due.  Although a low current ratio is not a sign of good financial health, it doesn’t necessarily translate into bankruptcy because there are many different ways that a company can secure short-term financing to meet its emergency needs. 

Leverage ratios. These types of ratios measure the degree to which a business is financed by debt.  One major business ratio under this category is the debt to equity ratio, calculated as follows: 

 

Debt to Equity ratio = Total Long-Term Debt / Owners’ Equity 

A high debt to equity ratio usually means that a business has aggressively financed its growth with debt.  The risk in this is that the interest costs of the debt will not be covered by the return that is generated by the growth. 

Activity ratios.  These types of ratios measure how effective the business is in using its resources.  One major business ratio under this category is the inventory turnover ratio, calculated as follows: 

Inventory Turnover ratio = Sales / Inventory 

The inventory turnover ratio for a specific operating period essentially shows how many times a business’s inventory is sold and replaced in that period. A low ratio is usually an indication of poor sales or excessive inventories. A high ratio usually indicates a high level of sales or insufficient inventories to meet customer demand. For more information on how to read financial statements, take a look at my article “Impress your bank manager! How to read your balance sheet”.

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