The word ‘ratio’ probably brings up traumatic memories from high school maths class, but in an accounting context, a ratio is a useful tool. Accounting ratios are part of the basics, and if you understand how to use them, you can measure how financially efficient and profitable your business is. That’s pretty powerful information to have at your fingertips.
Sound intimidating? Accounting ratios are quite simple to work with. You don’t need to be afraid of them, although we understand that many people are scared of numbers in general – which is partly why YourCFO exists! You also don’t need to be a CA to figure them out; read on to see why they’re nothing to fear, and why they’re an essential tool for the growth of your business.
What’s an accounting ratio?
An accounting ratio is the comparison of two or more financial data. This data is used for taking a closer look at a company’s finances so that its health can be better understood.
At YourCFO we get that business owners are often scared to delve into the world of numbers, but accounting ratios are amazing tools: they can give you an excellent idea of where your business is, and where it’s going. And you don’t need to use complicated equations to work them out, either. There’s just a handful that you need – once you get the hang of them, you’ll be able to see where your business needs to improve on.
Ratios are quite magical things.
The accounting ratios you need
While there are many accounting ratios out there, you only need to grasp a few of them to benefit from their numerical goodness.
The most useful ratios are:
The quick ratio
A quick ratio can tell you about your business’s short-term liquidity: i.e. how easy its assets can be converted into cash-money to pay off short-term debt.
The formula is:
(Current assets – Inventory) / Current liabilities
If your company has current assets of R90 000 and inventory of R30 000, your current asset total would be R60 000. You would then divide that number by the amount of your current liabilities, which are say, R35 000, to find your quick ratio.
R90 000 – R30 000 = R60 000 / R35 000 = 1.71
Ideally, you need at least a one-to-one ratio (you have more assets than debt).
The current ratio
Similar to the quick ratio, but the current ratio deals with your company’s ability to pay off long-term debt, and doesn’t deal with inventories.
The formula is:
(Current Assets) / Current Liabilities
So, you’d look at your balance sheet, and, depending on the numbers, you’d input:
R8 000 000 (current assets) / R4 000 000 (current liabilities) = 2.1 current ratio, which is good.
The higher the ratio, the better shape your company is in. But don’t panic if it’s on the low side, as lower ratios don’t automatically mean that the business won’t be able to pay its short-term debt without borrowing from the bank.
These measure how much a business earns versus how much it spends – money in and money out. These are a few of these, but the most useful ones include:
- (Return on Assets = Net Income/Average Total Assets)
The return on assets ratio will show how much profit a business makes compared to its assets.
- (Profit Margin = Net Income/Sales)
This will quickly tell you how much money comes from sales.
There are many different accounting ratios to use, but ideally, you should get a handle on those that are most relevant to your business. Once you know how to use them, you’ll be able to make better decisions for your business, from profit to growth. And that’s priceless.
Accounting ratios still not your thing? Contact us; we’re here to wrangle those numbers.