Having a basic understanding of accounting is essential to running a small business. Keeping up with various formulas and bookkeeping processes can be time-consuming, tedious work, but it can give you a clear picture of your company's financial health so you can make important decisions.
The first step to good accounting practices is accurate record-keeping on things like accounts receivable, accounts payable, inventory and other transactions in your business. You can use accounting software to do a lot of the hard work for you, but it still behooves you to know the basics of accounting, which include accounting ratios.
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Accounting ratios offer quick ways to evaluate a business's financial condition. According to Accounting Scholar, ratios are the most frequently used accounting formulas in regard to business analysis. Analyzing your finances with these ratios helps you identify trends and other data that inform important business decisions.
Here are the most common types of ratios and the various formulas you can use within each category:
- Liquidity ratios
- Profitability ratios
- Leverage ratios
- Turnover ratios
- Market value ratios
While it may not be possible to constantly analyze all of these ratios at a given time, it's crucial to pick a few that are pertinent to your business's operations so you can stay up to date on what's happening within your company.
These ratios are used to calculate how capable a company is of paying its debts, usually by measuring current liabilities and liquid assets. This determines how likely it is that your business will be able to pay off short-term debts. These are some common liquidity ratios:
- Current Ratio = Current Assets/Current Liabilities: The purpose of this ratio is to measure if your company can currently pay off short-term debts by liquidating your assets.
- Quick Ratio = Quick Assets/Current Liabilities: This ratio is similar to the current ratio above, except that to measure "quick" assets, you only consider your accounts receivable plus cash plus marketable securities.
- Net Working Capital Ratio = (Current Assets - Current Liabilities)/Total Assets: By calculating the net working capital ratio, you're calculating the liquidity of your assets. An increasing net working capital ratio indicates that your business is investing more in liquid assets than fixed assets.
- Cash Ratio = Cash/Current Liabilities: This ratio tells you how capable your business is of covering its debts using only cash. No other assets are considered in this ratio.
Cash Coverage Ratio = (Earnings Before Interest and Taxes + Depreciation)/Interest: The cash coverage ratio is similar to the cash ratio, but it calculates how likely it is that your business can pay interest on its debts.
- Operating Cash Flow Ratio = Operating Cash Flow /Current Liabilities: This ratio tells you how your current liabilities are covered by cash flow.
Accountants use these ratios to measure a business's earnings versus its expenses. These are some common profitability ratios:
- Return on Assets = Net Income/Average Total Assets: The return on assets ratio indicates how much profit businesses make compared to their assets.
- Return on Equity = Net Income/Average Stockholder Equity: This ratio shows your business's profitability from your stockholders' investments.
- Profit Margin = Net Income/Sales: The profit margin is an easy way to tell how much of your income comes from sales.
- Earnings Per Share = Net Income/Number of Common Shares Outstanding: The earnings-per-share ratio is similar to the return-on-equity ratio, except that this ratio indicates your profitability from the outstanding shares at the end of a given period.
A leverage ratio is a good way to easily see how much of your company's capital comes from debt and how likely it is that your company can meet its financial obligations. Leverage ratios are similar to liquidity ratios, except that leverage ratios consider your totals, whereas liquidity ratios focus on your current assets and liabilities.
- Debt-to-Equity Ratio = Total Debt/Total Equity: This ratio measures your company's leverage by comparing your liabilities, or debts, to your value as represented by your stockholders' equity.
- Total Debt Ratio = (Total Assets - Total Equity)/Total Assets: Your total debt ratio is a quick way to see how much of your assets are available because of debt.
- Long-Term Debt Ratio = Long-Term Debt/(Long-Term Debt + Total Equity): Similar to the total debt ratio, this formula lets you see your assets available because of debt for longer than a one-year period.
Turnover ratios are used to measure your company's income against its assets. There are many different types of turnover ratios. Here are some common turnover ratios:
- Inventory Turnover Ratio = Costs of Goods Sold/Average Inventories: The inventory turnover rate shows how much inventory you've sold in a year or other specified period.
- Assets Turnover Ratio = Sales/Average Total Assets: This ratio is a good indicator of how good your company is at using your assets to produce revenue.
- Accounts Receivable Turnover Ratio = Sales/Average Accounts Receivable: You can use this ratio to evaluate how quickly your company is able to collect funds from its customers.
- Accounts Payable Turnover Ratio = Total Supplier Purchases/(Beginning Accounts Payable + Ending Accounts Payable)/2): This ratio measures the speed at which a company pays its suppliers.
Market value ratios
Market value ratios deal entirely with stocks and shares. Many investors use these ratios to determine if your stocks are overpriced or underpriced. These are a couple of common market value ratios:
Price-to-Earnings Ratio = Price Per Share/Earnings Per Share. Investors use the price-to-earnings ratio to see how much they're paying for each dollar earned per stock.
- Market-to-Book Ratio = Market Value Per Share/Book Value Per Share. This ratio compares your company's historic accounting value to the value set by the stock market.
Why look at financial ratios for small business?
Accounting is the language of business. It tells a story. While these formulas may seem like arcane number crunching, the results are bellwethers of your business's health.
Running a successful business means learning from past mistakes and making healthy decisions for your future. Without a basic understanding of accounting, you can't plan for your business's future.
By taking the time to investigate and understand your business's financial health, you can make accurate decisions about your future and set your business up for success. For example, total debt ratio can serve as a key indicator of whether it's the right time to take a new loan. The asset turnover ratio shows how valuable your assets are in relation to what you're producing. This can inform how you increase business efficiency or whether you invest in new assets.
To run a successful business, you must have a clear picture of where you stand at any given time. Having clear books that are accurate and easy to interpret can ensure you're running a successful business.
Financial accounting vs. cost accounting
There is a key difference between financial accounting and cost accounting: Financial accounting addresses the current financial health of a business, while cost accounting assesses only costs associated with the production of your business. Both can be used to better understand the financial standing of your company, but cost accounting is focused on profit and efficiency.
Want to brush up on your basic accounting terms? Check out this infographic.