The Importance of Accounting Ratio Analysis in Small Business Appraisal

Small businesses owners must have a basic understanding of the accounting ratios. The ratios can help business owners to know about the financial performance of the company. It can also help in understanding different aspects of the business.

Business ratios reflect the positive and negative aspect of the business. You can get a clear picture of your business through looking at accounting ratios. It will help you in making sound financial decisions regarding your business.  The ratios are calculated from accounts maintained by professional CPAs of outsourced bookkeeping service providers.

What are Important Accounting Ratios?

Accounting ratios are calculated from figures included in the income statement and balance sheet. Here are some of the most important accounting ratios that you must consider to know about the financial health of your business.

Gross Profit Margin

Gross profit margin reflects how efficiently a business is earning an income from products or services offered to customers. The gross profit margin is calculated by deducting the cost of services or goods manufactured from the net revenues.

Net Profit Margin

Net profit margin is another important accounting ratio. The ratio shows efficiency of a business in earning a profit. The ratio is calculated by dividing sales by net profit.

Operational Profit Margin

Operating profit margin shows the level of cost controls and operational management. The operating profit margin of a company is calculated by deducting operating expenses from gross profit and dividing the resulting figure by net revenues.

Note: The figure obtained by deducting operational expenses from operating expenses is also referred to as earnings before interest and taxes (EBIT).

Liquidity Ratios

Liquidity ratios measure the ability of the business in paying back short term loans. The information is calculated by looking at figures from the balance sheet such as current assets and current liabilities.

An important liquidity ratio is the cash ration that divides cash or cash equivalents by current liabilities. The ratio shows how readily the company can utilize assets to pay back loans.

Quick and working capital (current) ratios are also commonly used liquidity ratios. Quick ratio is calculated by deducting inventory and prepaid expenses from current assets and dividing the figure by current liabilities. In contrast, working capital ratio is calculated simply by dividing current asset by current liabilities.

Cash Flow Ratios

Cash flow to debt ratio shows the ability of the business in meeting financial obligations. The ratio is calculated by dividing operating cash flow by debts. A higher ratio shows greater ability of the business in paying back the loan.

Operating cash flow measure shows the cash generated by the business from its operations. It is calculated by dividing operating cash flow by net sales.

Free cash flow to operating ratio allows small business owners to gauge the extent of free cash flow. A higher free cash flow is recommended that is calculated by deducting capital expenses from cash from operations.

Operational Efficiency Ratios

Operational efficiency ratios calculate the efficiency of the business in carrying out business activity. The ratios are calculated from information in the income statements.

Revenue per Employee

An important operational efficiency is to find out revenue generated by each employee that is calculated by dividing annual revenue by the average number of employees during a particular period.

Return on Total Assets

Another important operational efficiency ratio is the return on total assets. This ration is calculated by dividing net income by average total assets. This ratio reflects the efficiency of the business in generating income through assets. It is calculated by dividing net income by average net income by the average assets.

Inventory Turnover

Inventory turnover ratio reflects the efficiency of the business in selling inventory. It is important that you start with the average inventory figure rather than the inventory figure during a period. The ratio is calculated by dividing cost of goods sold by average inventory.

Accounts Receivable Turnover

Accounts receivable turnover reflects the efficiency of the business in managing account receivables. A higher rate means that the company is able to collect account receivables more quickly. The ratio is calculated by dividing average receivables during a period.

Average Collection

Average collection provides information to business owners about the time it takes to collect an amount due from customers. The ratio is calculated by  multiplying 365 by accounts receivable turnover ratio and dividing net credit sales.

Days Payable Outstanding (DPO)

DPO shows how long a company has been making payments to the suppliers and creditors. It reflects how well the business manages the cash flow of the business. The ratio is calculated by dividing average accounts payable by the cost of goods sold multiplied by the number of days during an accounting period.

Days Sales Outstanding (DPO)

DSO shows how long customers of the company pay to the company for goods and services. The ratio is calculated by dividing account receivable during a period by the net credit sales multiplied by the number of days in an accounting period.

Solvency Ratios

Solvency ratios determine the ability of the business to meet long term financial obligations. The ratio is calculated using figures taken from the balance sheet.

Debt to equity ratio is a solvency ratio that indicates the ability of the company in repaying the loan. The ratio is calculated by dividing total liability with shareholder’s equity.

Another important solvency ratio is the debt to asset ratio. This ratio provides information about the financing structure of the company. A high solvency ratio reflects that the small business is facing financial difficulties.

Conclusion

Small businesses can greatly benefit from looking at accounting ratios. The ratios help businesses to find out strengths and weaknesses. Business owners can make important financial decisions regarding the business by looking at the financial ratios.

Financial ratios can help improve business operations. You can compare the financial ratio of your company with other companies in the industry to find out how well the company is doing in comparison to others.

Maxim Liberty Inc has a team of experienced CPAs who can enter accounting information based on generally accepting accounting principles and standards. If you want to get in touch with our professionals, you should dial (703) 957-6938 today.