Reviewing financial statements is an important part of understanding the performance of a business. However, financial statements are just one piece of the puzzle when it comes to understanding the overall performance of a business. Financial statements can be complex and difficult to interpret, especially for those without a background in finance. One way to make sense of financial statements is by using financial ratios. Ratios are mathematical calculations that compare different financial statement items to each other and provide a way to understand a company’s performance in relation to industry standards or its own performance in previous periods. In this blog post, we will take a look at some of the top ratios that business owners should review with their bookkeeper when reviewing financial statements.
- Current Ratio: The current ratio measures a company’s ability to pay short-term obligations. It is calculated by dividing current assets by current liabilities. A current ratio of 1.0 or higher is considered healthy, as it indicates that a company has enough assets to cover its short-term liabilities.
- Quick Ratio: The quick ratio, also known as the acid-test ratio, is a more conservative measure of a company’s liquidity. It excludes inventory from current assets when calculating the ratio and is calculated by dividing current assets (excluding inventory) by current liabilities. A quick ratio of 1.0 or higher is considered healthy, as it indicates that a company has enough liquid assets to cover its short-term liabilities.
- Debt-to-Equity Ratio: The debt-to-equity ratio is a measure of a company’s financial leverage. It is calculated by dividing total liabilities by total equity. A low debt-to-equity ratio indicates that a company has a low level of debt and a high level of equity, and is considered to be financially stable.
- Gross Margin Ratio: The gross margin ratio measures the profitability of a business. It is calculated by dividing gross profit by revenue. A high gross margin ratio indicates that a business is making a large profit on each unit sold.
- Return on Equity (ROE): The return on equity ratio measures a company’s profitability in relation to its shareholders’ equity. It is calculated by dividing net income by shareholders’ equity. A high ROE indicates that a company is generating a high return on the investment of its shareholders.
- Inventory Turnover Ratio: The inventory turnover ratio measures how quickly a business is selling its inventory. It is calculated by dividing cost of goods sold by average inventory. A high inventory turnover ratio indicates that a business is selling its inventory quickly and efficiently.
- Accounts Receivable Turnover Ratio: The accounts receivable turnover ratio measures how quickly a business is collecting payment from its customers. It is calculated by dividing credit sales by average accounts receivable. A high accounts receivable turnover ratio indicates that a business is collecting payment quickly and efficiently.
It’s important to note that these ratios should be used as a guide, and that interpreting the ratios need to be seen in context. For example, the average current ratio for a company in a particular industry might be different than for another industry. Furthermore, it’s important to compare the ratios over time, as well as to industry averages, to get a better understanding of the company’s performance. By reviewing these ratios regularly with your bookkeeper and understanding the context in which they are being used, business owners can gain a deeper understanding of their financial statements and make more informed decisions.
Preferred Bookkeeping and Tax Services, LLC specializes in accounting and tax preparation services. We specialize in tax return filing and tax planning for individuals, Bookkeeping and financial statements for small businesses, Corporate tax return filing. We are based in Palm Coast, Florida. Our reach goes beyond our territory by offering virtual services.
Rachel Velez, founder of Preferred Bookkeeping and Tax Services, LLC, is a member of the National Association of Tax Professionals (NATP) and the National Association of Enrolled Agents (NAEA) and stays current with continuing professional education courses so that our firm stays on the leading edge of ever-changing tax laws and accounting methods. Schedule a free 15-minute consultation or contact us so that we can assist you.