Banks and investors will typically use financial ratios to measure the performance of your business. So you need to know the state of your business. They may also be used to gain insight into a company’s financial statements.
Use these 4 financial ratios to improve your accounting knowledge.
Quick Ratio / Acid Test Ratio
(Cash + Marketable Securities + Net Accounts Receivable) ÷ Current Liabilities = Quick Ratio
A quick ratio measures the liquidity of your business. It determines whether you have enough assets to pay your current liabilities.
This is useful if your business has liabilities such as short term loans, payables, income and payroll taxes, credit card debt and other expenses.
The higher your quick ratio, the greater your chance of re-investing in your business. A quick ratio of 5.0 means you have $ 5 of liquid assets to cover each $ 1.00 of liabilities.
If your quick ratio is less than 1.0, your debt is higher than your assets, which means that it is better to repay your loans before you spend more money on business expansion.
Cash Flow to Debt Ratio
(Net Income + Depreciation) ÷ Total Debt = Cash Flow to Debt Ratio
If your small business has cash problems despite making money every month, it will likely be delayed by paying off the loan. The cash-to-loan ratio is very useful in this case as the failure of small businesses is mainly attributable to cash flow problems.
The longer your loan repayment period, the higher your liquidity should be. If your cash loan ratio is less than 1: 0, then you need a few more sources of income to pay off your debt.
Net Profit Margin
(Total Revenue – Total Expenses) ÷ Total Revenue = Net Profit Margin
Your net profit margin is a percentage of your income. Almost every investor will use this ratio because it shows how successful the company is in converting it to profit.
If your net profit margin drops, it will be good to tighten finances.
If you spend more money expanding your business, you can expect this to drop. However, if the decline is due to other factors, you should immediately investigate them.
Net profit margin generally means finding a good valuation point for your products. It is generally good to have a profit margin of more than 10%. However, this may vary by industry.
Gross Profit on Net Sales
(Net Sales – Cost of Goods Sold) ÷ Net Sales = Gross Profit on Net Sales
Gross profit on net sales is a good indicator of the ideal price point for the goods and services sold. This ratio calculates whether your average markup will cover your expenses and how much.
If your gross profit on net sales is consistently low, then you probably end up with a very low price or spend too much on production. It is a good idea to calculate it regularly, as this can seriously affect your bottom line.
If you are worried about low gross profit on net sales, you should start tackling this problem early so you don’t spend too much.