Four Key Business Ratios
Understanding your business's cashflow and asset ratios will help you see if financial trouble is looming ahead. Using the numbers from your company's balance sheet, you can quickly compute several important ratios and figure out where your company stands in terms of liquidity, liabilities, and overall profitability.
Return on Investment, ROI
The return on investment ratio expresses profits as a percentage of the money invested. You can calculate ROI for an individual project or your entire business. By comparing the ROI with the rate of return on low-risk investments, such as CDs, you can judge whether your business investment is worth it. The equations are
ROIProject = (Earnings - Investment) / (Investment)
ROICompany = (Net Profit Before Taxes) / (Net Worth)
For instance, if the going rate for a certificate of deposit is 4.6% and your business is returning 4.5%, then investing in your business is worthwhile because the difference is small, and there is satisfaction in running a successful company. But if CDs are at 5.2% and your business is only returning 2%, you should consider reinvesting your business's assets in low-risk bank deposits rather than investing in back into your business.
The current ratio is the simplest measure of financial stability. This metric helps you gauge whether your company has enough cash and assets to cover its liabilities within the next 12 months. The equation is
Current Ratio = (Current Assets) / (Current Liabilities)
The higher the ratio, the more easily your business can pay its creditors. An acceptable asset-to-liability ratio is at least 1.5 to 1, though 2 to 1 is much better. If the current ratio is less than 1 to 1, it means your business does not have enough assets to pay its debts in case all of your creditors should swoop down at once and demand payment within the year.
Quick Ratio or Acid Test Ratio
The quick ratio or acid test ratio is similar to the current ratio, but it measures your company's ability to pay its current debts immediately with the cash and liquid assets on hand. Liquid assets include cash, accounts receivable, and cashable securities. Everything but inventory.
Quick Ratio = (Liquid Assets) / (Current Liabilities)
A 1 to 1 quick ratio is acceptable for most businesses. Keep in mind that accounts receivable is the least liquid of the three main components, so if most of your business's cash is in receivables, you should have a quick ratio higher than 1 to 1. See also Had2Know's Quick Ratio Calculator.
The leverage ratio is most complicated of the four ratios because its definition varies by area of finance and even by industry. Operating leverage describes how changes in the level of output impact the operating income. There are several formulas to calculate operating leverage; each equation is a function of the business's revenue, fixed costs, and variable costs.
Financial leverage describes how profitability varies as the ratio of debt to equity varies. There are several formulas for computing financial leverage as well, and each takes into account the company's debt, equity, and earnings.
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