Ratio analysis is a process that incorporates a series of simple mathematical functions and applies them to financial statements or projections to determine fiscal performance and conditions of a business enterprise.
They become even more valuable when you compare those ratios over time, from one period to the next. The primary use, however, should be to compare your ratio results with those of other businesses in your industry.
Some of the most basic ratio formulas, such as liquidity and debt ratios, are also the ones to which most small businesses pay the closest attention.
An example of liquidity ratios is current ratio, which indicates how well the company can cover all short-term debt with all current assets. The formula is total current assets divided by total current liabilities.
For example, a company has total current assets of $100,000 and total current liabilities of $75,000. Apply the formula as follows:
Total Current Assets $100,000/Total Current Liabilities $75,000 = 1.33.
The result indicates the company has $1.33 of current assets for every dollar of current liability. Many companies seek a ratio of 2.0 or better, though less can be acceptable.
The acid test takes the current ratio one step further for companies with inventory and is intended to indicate how well you can cover short-term liability with current assets less inventory. The formula is total current assets (minus inventory) divided by total current liability.
The concept of eliminating inventory is that it represents that portion of current assets, which are most difficult to liquidate immediately into cash. Take the example of the company that has $100,000 in total current assets, $25,000 in inventory and $75,000 in current liability. Apply the formula as follows:
Total Current Assets – Inventory ($100,000 – $25,000)/Total Current Liability ($75,000) = 1.0.
The result indicates the company has $1.00 of current assets (minus inventory) to pay for each dollar of current liability. This ratio should always equal 1.0 or more.
Debt ratio relates to a company’s ability to engage in borrowing. Two such examples are the debt ratio and the debt-to-equity ratio. The debt ratio (debt to assets) indicates how much a company relies on borrowing to finance its operations.
The formula is total debt divided by total assets. Consider the example of the company that has a total debt of $25,000 and total assets of $200,000. Apply the formula as follows:
Total Debt $25,000/Total Assets $200,000 = .121
This translates to 12.1 cents in debt for every dollar of total asset, an excellent ratio in any industry. The acceptable ratio level varies by industry.
The debt-to-equity ratio compares a company’s indebtedness to its net worth. The formula is total debt divided by total equity (net worth). Consider the example of the company that has a total debt of $25,000 and a total equity of $25,000. Apply the formula as follows:
Total Debt ($25,000)/ Total Equity ($25,000) = 1.0
This company has $1.00 of debt for every dollar of total equity. A debt-to-equity ratio of 1.0 is excellent in many industries. Again, the average varies from one industry to the next.
Business Roadmap can help you identify the rations best needed for your business and how to use these in your planning and management. Once you determine your ratios, you can compare them against other companies in the same industry.
SOURCE Note – RAN One