Financial Analysis: Essential Ratios Explained

Diving into financial analysis doesn’t have to be daunting. At New Heights Accounting, we aim to make complex financial ratios straightforward and understandable. In “Accounting Terminology and Not to Fear. (Part 2)”, we focus on key financial ratios, explaining their importance. Whether you’re running a business or just starting out, this guide is here to help you grasp the essentials of financial analysis with clarity. Let’s simplify these critical concepts together, enhancing your financial literacy.

Return on Sales

• This is a very important metric; it tells the owner of the business how profitable the business.
• Calculated by dividing the net profit of the business by the total amount of sales the business made over a period of time, usually a year.
• Important to measure against other businesses in the same industry.

Gross Margin Ratio

• The metric is very important also as it measures how much money is going to be available to pay operating expenses in the business.
• It is calculated by dividing the gross profit (net sales – cost of goods sold) by the net sales.
• It is used to generate a breakeven analysis or how much money a business needs to generate to pay its operating expenses and become profitable.

Debt to Asset ratio

• This ratio tells the owner and other stakeholders how risky the business is and how likely that the business can suffer a catastrophic failure.
• It shows much the owner of the business has invested in the business.
• It is a very important measure to any lending institution.
• It is calculated by dividing the amount of liabilities by the amount of total assets.

Cash Flow Ratio

• This is probably the most important aspect of financial analysis.
• There are many businesses that are very profitable but suffer from a lack of available cash.
• Cash flow funds the growth of the business.
• There are many factors that affect cash flow and will be described below.
• It is calculated by dividing the cash and cash equivalents by the current liabilities.

Inventory Turnover

• This is a measure of how quickly you can sell the inventory on hand or in stock.
• This measure affects cash flow as the more inventory that is on hand the more money that is tied up.
• This measure must be compared to other businesses in the industry.
• It is calculated by dividing the cost of goods sold by the average amount of inventory on hand.

Accounts Receivable Turnover

• When a business does business based on future payments for inventory or services provided today, it generates an account receivable.
• The inventory is purchased with cash and therefore will have to wait until payment.
• This is a use of available cash.
• This is calculated by dividing the net credit sales by the average accounts receivable.

There are plenty more ratios that a business can work with.

Schedule a meeting with New Heights Accounting to see how we can help you with your business.

Did you miss Part 1 on the Financial Essentials? Click here to read Demystifying Accounting Terminology.