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Common Business Ratios and What They Mean
Ratio analysis is a process that incorporates a
series of simple mathematical functions and applies them to financial
statements or projections to determine fiscal performance and conditions
of a business enterprise.
They become even more valuable when you compare those ratios over time,
from one period to the next. The primary use, however, should be to
compare your ratio results with those of other businesses in your
industry.
Some of the most basic ratio formulas, such as liquidity and debt
ratios, are also the ones to which most small businesses pay the closest
attention.
An example of liquidity ratios is current ratio, which indicates how
well the company can cover all short-term debt with all current assets.
The formula is total current assets divided by total current
liabilities.
For example, a company has total current assets of $100,000 and total
current liabilities of $75,000. Apply the formula as follows:
Total Current Assets $100,000/Total
Current Liabilities $75,000 = 1.33.
The result indicates the company has $1.33 of current assets for every
dollar of current liability. Many companies seek a ratio of 2.0 or
better, though less can be acceptable.
The acid test takes the current ratio one step further for companies
with inventory and is intended to indicate how well you can cover
short-term liability with current assets less inventory. The formula is
total current assets (minus inventory) divided by total current
liability.
The concept of eliminating inventory is that it represents that portion
of current assets, which are most difficult to liquidate immediately
into cash. Take the example of the company that has $100,000 in total
current assets, $25,000 in inventory and $75,000 in current liability.
Apply the formula as follows:
Total Current Assets - Inventory ($100,000 - $25,000)/Total Current
Liability ($75,000) = 1.0.
The result indicates the company has $1.00 of current assets (minus
inventory) to pay for each dollar of current liability. This ratio
should always equal 1.0 or more.
Debt ratio relates to a company's
ability to engage in borrowing. Two such examples are the debt ratio and
the debt-to-equity ratio. The debt ratio (debt to assets) indicates how
much a company relies on borrowing to finance its operations.
The formula is total debt divided by total assets. Consider the example
of the company that has a total debt of $25,000 and total assets of
$200,000. Apply the formula as follows:
Total Debt $25,000/Total Assets $200,000 = .121
This translates to 12.1 cents in
debt for every dollar of total asset, an excellent ratio in any
industry. The acceptable ratio level varies by industry.
The debt-to-equity ratio compares a company's indebtedness to its net
worth. The formula is total debt divided by total equity (net worth).
Consider the example of the company that has a total debt of $25,000 and
a total equity of $25,000. Apply the formula as follows:
Total Debt ($25,000)/Total Equity ($25,000) = 1.0
This company has $1.00 of debt for
every dollar of total equity. A debt-to-equity ratio of 1.0 is excellent
in many industries. Again, the average varies from one industry to the
next.
Your RAN ONE business development professional can help you determine
the ratios for your business. Once you determine your ratios, you can
compare them against other companies in the same industry.
Your RAN ONE business development professional also knows all about
benchmarking practice and will be able to help you create a clear
picture of your standing in the industry.
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