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7 Financial Facts To Know About Your Business
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Article 4: Financial Ratios
One of the most helpful management tools you can derive from your financial statements is key financial ratios that will help you gauge the financial health of your business. Following is a look at the most important small-business financial ratios:
Current ratio — Derived from the balance sheet, this ratio shows how many times current debt could be paid off with current assets. It’s used frequently by investors and lenders to measure liquidity, or your ability to pay bills on time and run your operations effectively. Lenders are generally looking for a ratio of 1.25 to 1 or higher in companies they’re considering financing. Here’s the formula:
Current Assets ÷ Current Liabilities
Debt-to-equity ratio — Another balance sheet ratio, this ratio measures your debt capacity. Not surprisingly, lenders are also very interested in this ratio. They generally want to see a ratio here of less than 3 to 1 or less, which indicates that your company is not over-extended financially. The formula:
Total Debt ÷ Shareholder’s Equity
Accounts receivable (AR) days — This measures how long it takes you to collect the money that’s owed to you. Compare your AR collection time to your terms of sale and your industry averages (visit RMA: The Risk Management Association at www.rmahq.org/RMA for industry benchmarks) to see how well you’re doing against your peers and your own internal standards. The formula:
AR x 365 ÷ Annual Sales
Accounts payable (AP) days — Conversely, this measures how long you take to pay your vendor invoices. You want to stretch your payables as long as possible without jeopardizing your good trade credit. The formula:
AP x 365 ÷ Cost of Goods Sold
Inventory turnover — This tells you how often your inventory “turns over” in a year. You should have specific goals for inventory turns — four times a year is a common inventory turn, but you can increase cash flow and profits without increasing sales by turning inventory faster. The formula:
Cost of Goods Sold ÷ Inventory
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