When gauging the financial health of your business, you should use ratios rather than absolute numbers. Profitability, liquidity, operating and solvency ratios should be considered. These ratios could alert you to trends which would require immediate action.
Profitabilty Ratios
The Gross Profit Margin measures your profit at the most basic level. Is your sales price reasonable based on the cost of what you are selling? If this ratio is less than one, you will never make a profit. If you sell your product for less than it costs, profitability will not be possible.
The Operating Profit Margin measures your profit based on your earnings before interest and taxes. It measures the efficiency of the business before considering any financing. When comparing the operating efficiency of similar businesses, this ratio can determine the most efficient one.
The Net Profit Margin is also referred to as the “bottom line”. It considers all expenses including interest. The net income is also referred to as the “bottom line”.
Liquidity Ratios
These ratios refer to the ability of an entity to obtain cash to satisfy financial obligations. Liquid assets would be found in the current assets section of the balance sheet.
The Current Ratio would determine whether your working capital is sufficient to meet your short-term obligations. A current ratio of 2.0 is a general rule, but this would be subject to the particular industry. Some industries are more capital intensive. A current ratio less than 2.0 might indicate difficulty in paying current obligations.
The Quick Ratio or “Acid Test” helps gauge your immediate ability to meet our financial obligations. It does not include inventory in the current assets. A Quick Ratio below .5 might be indicative of a shortage of working capital and difficulty in meeting current obligations.
Operating Ratios
The Inventory Turnover Ratio indicates the number of times the inventory “turned-over” during a given period. A higher ratio would be preferable and indicates that you are not holding an excessive inventory level in your warehouse, and accumulating costs that accompany it.
The Sales to Receivables Ratio measures the turn over of your receivables. The higher the number the better, which would indicate an efficient collection of receivables. A ratio that is too high or increasing over time could indicate an inefficient use of working capital. Like many of these ratios, they should be compared to similar companies in the same industry.
The Days Sales Outstanding measures the efficiency of your collection efforts. The lower the number the better, and if the number is increasing, more effort should be directed toward collections.
The Return on Assets is one of the most common financial measures and an effective tool to compare the profitability of two companies. A lower number may indicate that you found a more efficient way to operate through inventory management, quality control, financing, or technology.
Solvency Ratios
The Debt to Worth Ratio may also be known as “Leverage Ratio”. It describes how much debt is used to finance the business. It is never advisable to depend too much on debt financing, which can increase risk, and in addition, the related expenses can overwhelm a business.
Working Capital (Net of Current Assets and Current Liabilities) is used to gauge the ability of a company to weather difficult financial periods. This number, unlike all of the above, is not a ratio but an absolute amount. It is difficult to predict the ideal amount of working capital for your business, but an increasing trend should be considered a positive sign.