In the hustle and bustle of daily business, getting a firm grip on your company’s financial health may seem elusive. Fortunately, a wealth of diagnostic information — like the annual physical exam that highlights the need for a change in medication or a revised diet — is often displayed in plain sight on the company balance sheet or income statement. Performing simple arithmetic operations on key numbers can provide insight to pinpoint existing problems or correct weaknesses — aspects of your business that, if left unchecked, may evolve into crises. Especially when monitored over time, the following three ratios can spotlight your company’s vitality or lack thereof.
- Profit margin. Divide net income by net sales to arrive at this ratio. Commonly used to evaluate a firm’s efficiency in controlling costs and expenses relative to sales, the profit margin is often a good indicator of a firm’s financial health. In general, the lower a company’s expenses relative to sales, the higher the sales dollars available for other activities. Other things being equal, you want this number to remain stable or increase over time. A falling profit margin may signal that burgeoning expenses are draining any increases in sales revenue.
- Current ratio. Also known as the working capital ratio, this number provides insight into a company’s ability to meet its short-term obligations. Divide current assets (cash, receivables, inventories) by current liabilities (routine accounts payable, accruals for taxes and payroll, the current portion of long-term debt) to calculate this ratio. A current ratio of 1.0 means that you are able to meet current obligations without drawing down savings or charging up the company credit card. If this number drops below 1.0, you may be headed for trouble. Your goal: keep the current ratio well above that number. A healthy current ratio indicates that, like a financially solvent household, your firm is living within its means.
- Debt ratio. Divide total liabilities by total assets to find this ratio. This important number highlights the percentage of company assets that are contributed by creditors. Generally speaking, creditors prefer a low debt ratio because, if your business declines, their interests are better protected. In addition, a company with a low debt ratio (relative to other firms in the same industry) is often given preference by lenders.
Contact us if you’d like more information on how to evaluate your company’s profitability, liquidity, and stability over time.