A basic understanding of accounting is essential to running a small business. Keeping up with various accounting ratios and formulas, as well as bookkeeping processes, can be time-consuming, tedious work. But sticking with it can give you a clear picture of your company’s current financial health so you can make crucial decisions.
Accounting ratios measure your organization’s profitability and liquidity and can show if it’s experiencing financial problems. You can use them quarterly or annually, depending on your business type. They offer quick ways to evaluate your company’s financial condition and identify trends and other data to guide critical business decisions.
Understanding accounting ratios and formulas is worthwhile even if you choose accounting software to do much of the hard work for you. Essential ratios and formulas will differ according to your business’s needs. For example, a turnover ratio is crucial for brick-and-mortar retailers.
We’ll highlight commonly used accounting ratios to help you understand how they can benefit your business.
Liquidity ratios calculate how capable your company is of paying its debts. They typically measure current business liabilities and liquid assets to determine your company’s likelihood of repaying short-term debts.
Common liquidity ratios include the following:
Accountants use profitability ratios to measure a company’s earnings versus business expenses. Common profitability ratios include the following:
A leverage ratio helps you see how much of your company’s capital comes from debt and how likely it is to meet its financial obligations. Leverage ratios are similar to liquidity ratios. However, leverage ratios consider your totals, while liquidity ratios focus on current assets and liabilities.
Turnover ratios measure your company’s income against its assets. There are many different types of turnover ratios, including the following:
Market value ratios deal entirely with stocks and shares. Many investors use these ratios to determine if your stocks are overpriced or underpriced. Common market value ratios include the following:
Accounting is the language of business: It tells a story. While these formulas may seem like arcane number-crunching, the results reveal your company’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 firm’s future.
Investigating and understanding your business’s financial health allows you to make accurate decisions about your future and set up your business for success. For example, the total debt ratio can be a key indicator of the right time to get a business loan. And the asset turnover ratio shows how valuable your assets are in relation to what you’re producing. This can prompt you to increase business efficiency or invest in new assets.
There are various types of accounting. The accounting ratios and formulas we highlighted here involve figures from cost accounting, which determines how supply chain costs shape your actual manufacturing or service costs. This information is useful for external stakeholders but especially for internal ones, as the latter are in a position to make monetary changes.
Financial accounting is another accounting type. This approach focuses on your company’s financial standing rather than its ongoing costs. While financial accounting addresses the current financial health of your company, cost accounting assesses only costs associated with your business production.
If financial accounting is all about balance sheets and income statements, cost accounting is all about ratios and formulas. Realistically, you need both types of accounting — and that’s why most small businesses hire an accountant. Financial and cost accounting processes involve time-consuming work, so you’re better off delegating the responsibility to a third-party professional. This way, you can spend time on your most pressing tasks — the ones only you can do.
Sure, your accounting software will automatically calculate and track all your ratios. But that’s only meaningful when you understand what these ratios signify for your business. Remembering ratios and formulas can feel overwhelming, but you don’t have to memorize them — just understand them. And whenever you need a refresher, come back to this guide. Keep it handy as you look at your accounting software to help you truly see your company’s complete financial picture.