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Financial ratios are used as a tool to analyse the financial situation of your business through its financial statements.  It allows you to determine your business' progress in achieving business goals, particularly when compared with budgeted ratios.  By comparing your business' current period's ratios to previous years, you can perform a trend analysis to identify if your business has improved from one year to the next.

Following are some of the most common ratios:

Solvency Ratios: enable you to analyse your business' ability to pay its long-term (greater than 12 months) debt obligations.

Debt Ratio: compares the level of debt you have to finance your business compared to the amount of equity, or capital contributions made by business owners to the business. It is reflected as a number. 

Typically a debt ratio of greater than one indicates that your business has more debt than assets and may experience difficulties in the longer term to repay long-term debt obligations. Therefore, a lower ratio is preferable, as this means that your business has more assets than liabilities.

Profitability Ratios: used to assess your business' ability to generate income from the expenses incurred during the period.

Net profit margin: determines how much profit your business generates for every dollar of revenue, it is expressed as a percentage (%). It is usually reflective of your business' pricing margin.

Return on assets: determines how efficient assets are being used to generate income, this is expressed as a percentage (%).

Usually, a high return on assets may typically be representative of a high profit margin, a rapid turnover of current assets, or both.

Liquidity ratios: enable you to analyse your business' ability to repay short term (less than 12 months) debt obligations.

Working capital ratio (or current ratio):  determines whether your business has enough current assets to cover its current or immediate liabilities.

A ratio that is less than one means your business may not have enough current assets, which are those assets that can be readily converted into cash, to meet short-term debt obligations.  This could typically be the result of an increase in short-term debt, a decrease in current assets, or both.

Inventory turnover ratio: indicates how quickly your business is using or turning its stock.

A low turnover ratio may indicate that either your business' inventory is naturally slow moving or that there may be problems with your inventory such as the presence of obsolete stock or low customer demand for the inventory, or in fact you are ordering far too much at a time and it is sitting on the shelf.

Receivables turnover ratio: indicates your business' effectiveness at collecting its due account receivables, that is, the number of times receivables are collected within the period.

A high ratio implies that either your business is operating on a cash basis or is effective at collecting its receivable accounts as they fall due.

All ratios should be calculated regularly to measure the effectiveness and efficiency of the financial management system the business has in place.