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How to Use Financial Ratios

By: Garry Crystal - Updated: 11 Oct 2012 | comments*Discuss
Ratios Business Liquidity Accounts Money

Learning how to use financial ratios may seem like a daunting task to those who are not numerically minded. Once you actually get past the fear of using financial ratios you should find them easy to use and an essential tool that will aid your business.

Why Use Financial Ratios?

Financial rations are a way of calculating your company’s strengths and weaknesses. Many important issues can be viewed by using financial ratios such as excess stock problems, bad credit payers and problems with operating costs.

At its most basic form, financial ratios are simply the process of comparing information from balance and income sheets to examine the performance of your company. The other way to use ratios is, as explained above, to undercover issues that may be causing problems within your company.

Working Out The Ratio

Ratios are comparisons; they are the relationship between two numbers. The ratio will always be made up of a numerator and a denominator although various combinations of figures may make up the numerator and denominator. The ratio will be worked out by dividing one number by the other and the outcome will usually be worked out as a percentage.

Almost any statistic can be found by using financial rations, although businesses will use them for their own particular requirements. A typical ratio will be - total sales/the number of employees, this will work out the productivity within your sales force.

Types Of Financial Ratios

As mentioned, ratios can be used to work out practically any statistic but businesses will be interested in particular figures. Typical ratios used in business will be liquidity, efficiency and profitability ratios. By using these formulas companies can see where they are going wrong and look for ways to improve their business in the future. One thing to bear in mind is that the repeated use of these formulas must be consistent in order to show progression over a period of time.

Efficiency Ratio

Using an efficiency ratio will allow you to assess such issues as stock, credit and company assets. An efficiency ratio can show how much stock is being turned over or how much money is coming in from sales made with credit. The outcome of the ratio can determine whether or not an adjustment is needed in stock levels or whether or not credit is being used or abused by customers.

Liquidity Ratio

A liquidity ratio will be able to determine if a company is able to meet its business obligations. This ratio will take into account of how much funds are available to pay debtors and other current liabilities. In some cases stock will be eliminated from the formula because it will not be easily converted into funds. Most businesses consider the liquidity ratio to be the most important as it can show the amount cash available to keep the business running.

Profitability Ratio

The profitability ratio is used to determine the amount of profit your company is making. Different formulas will give you answers to different profitability questions. For example you can work out your gross profitability or your net profitability. You can also work out the amount of sales per employee or the return on your assets or investments. Using a variety of ratios will bring the profitability outcome that you wish to investigate.

Financial ratios should be used on a regular basis to keep track of your company’s performance. They are an important procedure and will usually be undertaken by the accounts department if you have one. If you undertake your own accounts then these formulations are not hard to maintain as long as you are consistent. Always use the most up to date figures when you use a financial ratio and make sure that you actually implement any changes that are needed to rectify negative results.

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