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Understanding what Your Ratios are Telling You

How's business? Most business owners can answer that question without consulting a financial statement. But what if someone asks about "return on assets" or "average collection period"? To answer those questions, you need the help of financial ratios.

Inside the Numbers

A financial ratio is the numerical relationship between certain figures on your income statement and balance sheet. "Profit margin" is probably the most familiar financial ratio. Expressed as a percentage, profit margin is calculated by dividing net income by sales.

There are many useful ratios. They can provide information about liquidity, turnover, and debt, as well as profit. Digging "inside" the numbers can reveal such things as how quickly receivables are collected, how frequently inventory is turning over, and whether you're in a good position to repay your financial obligations on time.

Putting Ratios to Work

While the numbers themselves are interesting, the real value comes from analyzing financial ratios. You can use ratios to spot trends, both good and bad, by comparing your company's current situation with the past. And ratio analysis can help you with forecasting and goal setting.

Ratios can also be used to compare your company's financial performance with that of other companies and with the industry as a whole. Another important use: Bankers frequently review a company's financial ratios as part of the loan application process.

Some Common Ratios

The following key financial ratios are essential business management tools.

Current Ratio Current assets ÷ current liabilities Does the company have sufficient resources to meet current liabilities when they come due?
Debt-to-Equity Total liabilities ÷ stockholders' equity How heavily is the company leveraged?
Gross Profit Margin Gross profit ÷ sales How much profit is available to cover operating expenses?
Net Profit Margin Net income ÷ sales How much profit is earned on each sales dollar after all expenses are accounted for?