Becoming an entrepreneur may be one of the hardest journeys you can make in your life. When you make the decision to enter the business world as an entrepreneur, you quickly come to understand that with the territory. You have a responsibility to learn.
Of those things you learn are Financial Ratios. They are imperative in measuring how effective you were historically, are presently doing, and could potentially do. And of the many different ratios that are used, the most valuable ones for entrepreneurs and managers are Profit, Liquidity, Working Capital, and Leverage Ratios.
- Profit Ratios -
When in business for yourself, the first thing you must consider is the profitability of your business. Without the lifeblood of profit, your business will not grow and will always be at high risk of kicking the bucket.
And with Profit Ratios, you can avoid such pitfalls by knowing how well competitors are doing in your industry or gauge how well you’re doing. Because if the industry or you have low profit ratios, it may not be a good business to get into or it might be high time to sell your business and reinvest.
Now profit ratios use a combination of gross profits, net income, net sales, total assets, and owner’s equity. You can quickly understand your business position at that moment in time. To make it even easier use an online financial calculator.
A few samples:
- Measures how much money is left after others take a bite (Creditors, Vendors, etc.)
- Weak Net Profit indicates something is eating up your bottom line
- Shows effectiveness of utilizing equity invested into the company
- Most important for investors who are looking to lend you money as they want a great return
- Liquidity Ratios -
As an entrepreneur, profit comes first, but liquidity comes second because no matter how much you have in assets. It won’t keep the creditors from knocking on your door if you don’t have the money they want right now.
Liquidity Ratios measure just that. Showing your ability to pay your current obligations. Knowing your liquidity allows you to adjust your daily operations to bring in enough money to avoid problems before they start.
With liquidity ratios, the most important parts on the balance sheet are liabilities to be combined with Current Assets and Liquid Assets. To make it even easier use an online financial calculator.
A few samples:
- Represents your ability to pay your debts up to a year
- The general rule of thumb is that it should be at least 2:1; two dollars for every one you owe
- Represents your ability to pay now
- The general rule of thumb is that it should be at least 1:1; always have enough money on you to keep the loan sharks at bay
Working Capital is essentially what you’re currently using to make money. This includes credit, inventory, and assets. As an entrepreneur, you must constantly assess your ability to utilize working capital as it is the bread and butter of your daily activity. Without these ratios you will have no idea if something needs optimized or shut down.
These ratios deal mostly with Sales, Working Capital, Inventory (Key), and Assets. To make it even easier use an online financial calculator.
A few samples:
- reflects your ability to finance your activities and its efficiency
- in general you need to five more coming in sales than you have in working capital as it has many cash leaks that may sink the ship
- Shows how tied up your assets are in your inventory
- Because if you need new inventory, but you can’t buy it until you sell your old inventory, then you have a mighty fine problem
Leveraging is using other people’s money to finance what you’re doing. With leveraging you experience higher returns by having capital you normally wouldn’t’ have. But with more leverage, the higher the risk of bankruptcy if your working capital isn’t working for you, and your bills come due. Knowing your leverage is great because you know if you can to take on more debt without compromising yourself.
Leverage Ratios deal mostly with how much debt you have compared to other things like Owner’s Equity, Assets, and Expenses. To make it even easier use an online financial calculator.
- shows you the portion of your assets that you have through borrowing
- Never owe more than you own. On this situation you are technically bankrupt and one simple call from a creditor will bring you to your knees
- alerts you on how comfortably you can handle interest payments
- can’t handle it = can’t take on more debt, can’t grow, can’t become more profitable; can handle it = can take on more debt, can grow, can become more profitable. Everyone’s happy.
But before you start using these ratios, you have to accept these simple truths…
- What determines good and bad ratios for you are based on your industry, the maturity of your business, and the business cycle
- For ratios to be useful, you have to keep in mind that they are time sensitive and only present a certain block in time for your company.
- True benefits of Financial Ratios can only fully realized when tracked over time and compared to competition and similar industries
- And ratios must also be taken with a grain of salt for the short term can quickly turn forecasts