The four most common types of ratios are liquidity, asset management, profitability, and leverage. Let's take a closer look at each.
Liquidity is used to determine if you have enough cash to cover your immediate debts. What is an immediate debt? Anything that's due within the next 12 months.
This number changes almost daily for some businesses.
It includes interest due on an operating line of credit. Bills payable like insurance, utilities, and supplier bills. Current debts also include payroll and taxes due.
To pay these current debts, you'll need assets that are easily converted to cash. AKA, current assets. Current assets include cash, accounts receivable, and inventory on hand.
Common liquidity ratios include:
Asset Management Ratios or Efficiency Ratios
This category of financial ratios determines how efficient your business is at turning its assets into sales. The most common ratios in this category are:
- inventory turnover
- receivables turnover
Both of these ratios calculate time, such as the time it takes your company to convert inventory into sales. Or how long it takes your company to collect receivables.
Why are these important?
The longer your company holds onto inventory, the less money you'll make in the long run. Same with receivables.
Of course, both of these ratios are only useful as they relate to the industry. In general, you want to see both of these numbers under 30 days.
Certain industries have longer billing cycles. An example would be road construction. Road construction is almost always funded by the local, state, or federal government.
These agencies tend to take longer to pay. Therefore, a 60-day receivables turnover might be okay.
These ratios show how well your business generates income relative to its expenses. The most common include:
- profit margin
- return on assets
- return on equity
Profit margin determines how much bottom line income you produce after you've deducted expenses.
Return on assets (ROA) shows how well your company is at using assets to create income. A higher ROA in relation to your industry means you make more money using fewer assets.
Return on equity (ROE) is like ROA but it uses equity instead of assets.
Leverage ratios tell you how leveraged your company is. By leveraged, we mean how much debt you have relative to the value of your company. A large, highly leveraged company is worth less than a smaller company with very little debt.
The most common leverage ratio is:
It's calculated exactly as it sounds: total debt divided by net worth.
Again, your D/W depends on your industry. Some industries, like finance, need more leverage than others. But in general, you want your D/W to be below 1:1. Meaning, your debt is less than or equal to your net worth.
An important ratio for determining cash flow is the debt service coverage ratio (DSCR). It tells you how well your business can repay debt obligations.