Building Long-term Value: Plan on It
"Everything has a price, as the saying goes, but a lot of p...
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Is a net profit of $200,000 on an income statement good? Look at the ratios. If it's earned on sales of $600,000, it could be. But if sales were $2.5 million, then the ratio is certainly less appealing. More sales were needed to produce that result. In other words, net income of $200,000 is 33.3 percent on sales of $600,000 and only 8 percent on the $2.5 million sales figure. If used properly, financial ratios can become powerful tools in determining what's happening—and what will happen—in a business. So how can ratios best be used?
Here are a few examples:
The quick ratio is also referred to as the acid test and gets to the nitty gritty of a business quickly. It subtracts inventory from current assets and then compares the figure to current liabilities. The quick ratio gives businesses a better picture of their ability to meet short-term obligations, since inventory can only be turned into cash once it's sold, which can take time. A stable current ratio with a declining quick ratio may indicate that too much inventory is on hand. A good acid test is a quick ratio of 1:1.
Monitoring your financial ratios on a regular basis offers insight into how effectively you're managing your business. While liquidity is among the chief financial ratios, there is a wide range that acts as indicators for the overall status of your business. In terms of profitability, for example, you might want to look at ratios such as:
Sources: "The Importance of Financial Ratios," Minnesota Business; "Financial Ratios," Small Business Notes
Salem Five's Financial Ratios Calculator can help you manage your business's profitability, efficiency, and liquidity. Simply input a quick series of different, easily accessible values, (e.g., Total Current Assets, Total Current Liabilities, Sales, etc.), and you'll receive a wide range of different Profitability, Operating, Liquidity, and Solvency ratios specific to your business.