Financial ratios are useful tools for business owners to monitor, analyse and improve their business performance. By using ratio analysis methods, you can gain insight into a company’s liquidity, efficiency and profitability by comparing the information contained in its financial statements.
Solvency:
Solvency ratios measure the company’s capacity to fulfil long-term financial commitments. Debtor days is one of the key measures of this ratio analysis method. It shows the average number of days that a business takes to collect invoices from their customers. The longer it takes to collect, the greater the number of debtor days. When debtor days increase beyond normal trading terms, it indicates that the business is not collecting debts from customers as efficiently as it should be. The formula for working out debtor days is:
(Trade receivables ÷ Annual credit sales) x 365 days
Profitability:
Profitability ratios help measure and evaluate the ability of a company to generate income relative to revenue, balance sheet assets, operating costs and shareholders’ equity during a specific period of time. The net profit margin measures what percentage of each dollar earned by a business ends up as profit at the end of the year, the formula is:
Net income ÷ Total revenue = Net profit margin
Liquidity:
Liquidity ratios measure a company’s ability to pay off its short-term debt obligations. This is done by comparing a company’s most liquid assets, those that can be easily converted to cash, with its short-term liabilities. Current ratio indicates whether a company has the liquidity to meet its short-term obligations. The formula is:
Current assets ÷ Current liabilities = Current ratio
Activity:
Activity ratios measure the efficiency in which management runs the company. Inventory turnover is an important activity ratio, showing how effectively a business is using its inventory. This ratio measures how many times the company’s inventory has been turned over or sold during a specified period. The formula is:
Cost of goods sold ÷ Average inventory = Inventory turnover
