Business Management Ratios For Small Businesses | Important Financial Ratios For Small Business
Welcome back to our part two (2) in this three-part article series on the Use of Financial Ratios For Small Businesses – today we will continue with part two (2) . You can go back to part one (1) here.
Accounts Receivable Turnover Ratio: Net Sales ÷ Receivables
This ratio measures the number of times Accounts Receivable turn over in one year. The greater the turnover, the shorter the time period between sale and the collection of cash. If a company’s receivables are turning slower than the rest of the industry, an examination of the company’s collection procedure and quality of receivables should be closely examined.
This ratio may also be misleading if the company’s cash sales represent a large percentage of total sales. Keep in mind that this ratio does not recognize cash sales.
Inventory Turnover Ratio: Cost of Goods Sold ÷ Average Inventory
This ratio measures the number of times inventory is turned over during the year. High inventory turnover can indicate better liquidity or superior merchandising. Conversely it can indicate a shortage of needed inventory for sales.
Key Financial Ratios For Small Business
Low inventory turnover can indicate poor liquidity, possible overstocking, obsolescence, or in contrast to these negative interpretations a planned inventory buildup in the case of material shortages.
When the inventory figure is zero, the quotient will be undefined and represents the best possible ratio.
This ratio is considered a significant indicator of the efficiency of operations for many businesses. This ratio is used to measure the speed with which inventory was being sold and replenished during the past year. As a general guideline, a high ratio suggests an efficient inventory system.
Payables Turnover Ratio: Cost of Sales ÷ Trade Payables
This ratio measures the number of times that trade payables turn over in one year. The higher the turnover, the shorter the time between purchases and payments.
If a company’s payables turn over more slowly than the industry, the company may be experiencing cash shortages, disputing invoices with suppliers, enjoying extended credit terms or deliberately expanding its trade credits.
Working Capital Turnover Ratio: Net Sales ÷ Net Working Capital
Working capital (current assets minus current liabilities) is a measure of the margin of protection for creditors. It reflects the ability of the company to finance current operations. Relating the level of sales generated by the operations of the company to the working capital supporting these operations, measures how efficiently working capital is employed.
A low ratio may indicate an inefficient use of working capital while a very high ratio may signify overtrading and a vulnerable position for creditors.
This relationship indicates whether a company is overtrading or conversely carrying more liquid assets than needed for its volume.
Each industry can vary substantially and it is necessary to compare a company with its peers to see if it is either overtrading on its available funds or being too conservative. Companies with substantial sales gains often reach a level where their working capital becomes strained.
Fixed Assets To Net Worth: Net Fixed Assets ÷ Net Worth
Net Worth is defined as Retained Earnings plus Current Year to Date Earnings plus Capital Stock. This ratio measures the extent to which stockholder’s equity (capital) has been invested in facilities and equipment (fixed assets).
A lower ratio shows a proportionately smaller investment in fixed assets in relation to net worth, and a better “cushion” for creditors in case of liquidation.
Key Financial Ratios For Small Business | Important Financial Ratios For Small Business
Similarly, a high ratio would show the opposite situation. The presence of substantial leased fixed assets(not shown on the balance sheet) may deceptively lower this ratio.
The portion of net worth that consists of fixed assets will vary greatly from industry to industry, but generally a smaller proportion is desirable.
A high ratio is unfavorable because heavy investment in fixed assets indicates that either the concern has a low net working capital and is over trading or has utilized large funded debt to supplement working capital.
Also, the larger the fixed assets, the bigger the annual depreciation charge that must be deducted from the income statement. Normally, fixed assets above 75 percent of net worth indicate possible over investment and should be examined with care.
Joint us in the conclusion of this three (3) part article series Performance Ratios For Small Businesses
You can go back to part one here – Use of Financial Ratios For Small Businesses.