Financial calculations or ratios will help you assess the financial position and performance of your business. These calculations are good for your own insights into your business and almost always necessary if you want to get funding or want to sell your business.
A ratio is basically a comparison, relating one number to another. In this article, we look at three simple ratios you can use to determine your business’s ability to meet its short-term financial obligations (liquidity ratios) and its long-term financial obligations (solvency ratios).
Liquidity ratios measure the ability of your business to convert its current assets to cash. Current assets include cash and other assets or possessions that can be easily converted into cash. Here are two simple ratios you can use.
Current ratio (or working capital ratio): This ratio tells you whether your business has enough current assets to meet its short-term financial obligations as they become due. You get this ratio by comparing (or dividing) your currents assets with your current liabilities. Most funders are happy with a ratio of 2:1. If the ratio is less than 1:1, it can indicate difficulties in meeting your obligations. You can improve this ratio by paying off your debt, putting purchases on hold, or considering longer-term borrowing to repay short-term debt.
Quick ratio (or acid test): This is a more conservative ratio as it does not include stock (inventory) in your current assets. You get this ratio by comparing (dividing) your current-assets-less-inventory with your current liabilities. The ideal ratio differs per industry, according to the nature of the stock held. If the ratio is substantially above 2:1 it can indicate that your capital is being underutilized. You can improve this ratio by investing more of your capital in projects that drive growth.
Solvency assesses your business’s ability to meet its long-term financial obligations. Here is a solvency ratio measuring debt versus equity.
Gearing ratio: This ratio can show to what extent the business has been funded by the business owner compared to other parties such as financiers or creditors (outside liabilities). You get this ratio by comparing or dividing your total outside liabilities by your equity (net capital). Funders generally like to see that the level of own funding measures up with that provided by other parties.
Doing a simple financial ratio analysis, using accurate information, you can learn a lot about the financial position of your business and make necessary adjustments to enhance your performance.
For more information, see Liquidity ratios on page 44 and Solvency ratio on page 45, The Nedbank Essential Guide for Small Business OwnersFor more information, see Liquidity ratios on page 44 and Solvency ratio on page 45, The Nedbank Essential Guide for Small Business Owners