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Tools That Work For You: Financial Ratios
Financial ratios are excellent tools used in financial analysis and planning. They commonly compare items on the balance sheet or income statement with other items on these statements. Good business owners and managers use them to compare and analyze the past and present financial condition of a company.
Also, reviewing the past years' ratios will pinpoint trends, which can be used to forecast the future. You will find the exercise of comparison quite revealing. To get an idea of how financial ratios can help you, let's examine two financial ratios: the Debt-To-Worth Ratio and the Current Ratio.
Look at the Liabilities and Equity portions of your balance sheet to determine your Debt-To-Worth Ratio. That ratio simply shows the relationship between your total liabilities (debt) and your owner's equity (worth). If your total liabilities are $300,000 and your owner's equity is $158,000, then your Debt-To-Worth ratio is $300,000 divided by $158,000, or 1.9:1. Obviously, the higher this ratio, the riskier the business. With a Debt-To-Worth ratio of 1.9:1, you'd have about $1.90 in liabilities for every dollar in equity.
The Debt-To-Worth ratio is valuable both for what it says about the condition of your company at the moment you create the balance sheet and for what it tells you about the direction your business is taking. If your goal is to strengthen your business, and your last four balance sheets show a steady decline in the Debt-To-Worth ratio, you are on the right track.
The Current Ratio, also derived from your balance sheet, measures how much money is available in current assets to meet current liabilities. It is a test for solvency. If you have a Current Ratio of 1.5:1, then for every dollar of liabilities due in a year, you'd have $1.50 of current assets (cash plus accounts receivable plus inventory). Adequate working capital varies from industry to industry, but $2 of current assets for every $1 of current liabilities is generally safe.
The Debt-To-Worth Ratio and the Current Ratio are excellent tools for quickly monitoring the strength of your business. As you know, increased sales do not guarantee improved financial strength, but these ratios will be a sound measuring device (and you can check them in seconds)!
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