Using Viability Ratios to Understand the Health of Your Business
It is one thing to run a business, it is another to understand the health of your company to its core. Once you’ve got a handle on your financial sheets (if you don’t, check out our previous blog!), you should have a pretty good idea of where your business stands financially. But in order to really understand the finer details of your business’s financial health, you need to be aware of both financial statements and business viability ratios.
What Are Business Viability Ratios?
Business viability ratios, derived from financial statements, are key indicators used to gauge a company’s ability to sustain operations, meet financial obligations, and grow over time. These ratios provide valuable insights into different aspects of a business’s financial health, including profitability, liquidity, efficiency, and solvency.
Key Financial Statements for Ratio Analysis
Before we dive into specific ratios, let’s quickly recap the financial statements from which these ratios are derived:
- Balance Sheet: Provides a snapshot of a company’s assets, liabilities, and shareholders’ equity at a specific point in time.
- Income Statement: Shows the company’s revenues, expenses, and profits over a period of time.
- Cash Flow Statement: This statement details the inflows and outflows of cash, highlighting the company’s operating, investing, and financing activities.
Profit Earning Ratios
Profit-earning ratios assess a company’s ability to generate earnings relative to sales, assets, and equity.
Gross Profit Margin
Formula: Gross Profit Margin = (Gross Profit / Revenue) * 100
This ratio indicates how efficiently a company produces goods or services. A higher gross profit margin suggests better efficiency and cost management.
Net Profit Margin
Formula: Net Profit Margin = (Net Profit / Revenue) * 100
This ratio measures the overall profitability of a company, indicating how much net income is generated from total revenue. A higher net profit margin means the company is more effective at converting revenue into actual profit.
Return on Assets (ROA)
Formula: ROA = (Net Income / Total Assets) * 100
ROA shows how efficiently a company uses its assets to generate profit. A higher ROA indicates better asset utilization and management.
Liquidity Ratios
Liquidity ratios evaluate a company’s ability to meet its short-term obligations. These ratios are crucial for assessing the financial stability of a business in the near term.
Current Ratio
Formula: Current Ratio = Current Assets / Current Liabilities
The current ratio measures a company’s ability to cover its short-term liabilities with its short-term assets. A ratio above 1 indicates that the company has more current assets than current liabilities, suggesting good short-term financial health.
Quick Ratio
Formula: Quick Ratio = (Current Assets – Inventory) / Current Liabilities
Also known as the acid-test ratio, the quick ratio provides a more stringent measure of liquidity by excluding inventory from current assets. This ratio assesses a company’s ability to meet short-term obligations without relying on the sale of inventory.
Efficiency Ratios
Efficiency ratios, also known as activity ratios, evaluate how well a company utilizes its assets and manages its operations.
Inventory Turnover Ratio
Formula: Inventory Turnover Ratio = Cost of Goods Sold / Average Inventory
This ratio measures how many times a company’s inventory is sold and replaced over a period. A higher inventory turnover indicates efficient inventory management and strong sales performance.
Accounts Receivable Turnover Ratio
Formula: Accounts Receivable Turnover = Net Credit Sales / Average Accounts Receivable
This ratio assesses how effectively a company collects revenue from credit sales. A higher ratio indicates efficient credit and collection processes.
Solvency Ratios
Solvency ratios, or leverage ratios, evaluate a company’s long-term financial stability by measuring its ability to meet long-term obligations.
Debt to Equity Ratio
Formula: Debt to Equity Ratio = Total Liabilities / Shareholders’ Equity
This ratio compares a company’s total liabilities to its shareholders’ equity, indicating the degree to which the company is financed by debt versus equity. A lower debt-to-equity ratio suggests a more financially stable company with less reliance on borrowed funds.
Interest Coverage Ratio
Formula: Interest Coverage Ratio = EBIT / Interest Expenses
The interest coverage ratio measures a company’s ability to pay interest on its outstanding debt. A higher ratio indicates that the company generates enough earnings to cover its interest expenses comfortably.
Business viability ratios are powerful tools derived from financial statements that provide critical insights into a company’s financial health and operational efficiency. By analyzing profitability, liquidity, efficiency, and solvency ratios, businesses can make informed decisions to enhance their financial stability and growth prospects. Understanding and utilizing these ratios is essential for business owners, investors, and financial analysts aiming to assess the sustainability and success of a company.
Whether you’re a seasoned business owner or new to the world of business, understanding these financial ratios will equip you with the knowledge to navigate the complex financial landscape and ensure long-term success. Need a little help navigating the many different viability ratios? Our expert team is ready to help! Give us a call at 416-646-0550 or request a consultation to get started.