Accounting Rate Of Return Is Based On Cash Flow Ratio Analysis Techniques for Improving Your Small Business

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Ratio Analysis Techniques for Improving Your Small Business

Ratio analysis enables you to spot trends and measure business performance by providing important information that allows you to identify and fix problems before your business is used.

Although ratio analysis can be complex in nature. There are some basic ratios that you can measure as a small business owner to determine liquidity (does my business have enough liquid to cover expenses), activity (does my business activities generate good returns) and profitability (is my business making a profit margin? I expect ). Let us consider these ratios in detail.

1. Liquidity Ratio- Measures your ability to meet your short-term goals. For example: You can use your balance sheet to pay all your bills today. We will use the quick ratio formula for this answer.

Quick Ratio = Current Assets-Inventory-Current Liabilities;

In this example we will use a service business which we will ignore the list

Let’s say your current assets are $10,000 in cash, $15,000 in receivables, and $8,000 in common stock.

Your liabilities are $30,000 in accounts payable and $8,000 in notes payable.

Your target ratio > 1.1

$33,000 = 0.87

$38,000

Problem: Your current liabilities exceed your current assets.

Solution: Set new terms for your receivables or find ways to increase your cash flow. See numbers never lie, so with this new information you can implement strategies aimed at growing your current assets.

Next let’s look at the activity ratio

2. Activity Ratio- Measures how efficiently your business resources are being used (average collection period, inventory turnover). For this example we will look at the inventory turnover for a discount store i.e. 99 stores.

Inventory Turnover – Measures how many times inventory is turned over in a given year. The higher the turnover rate, the better. Now to calculate this ratio you also need to know what your industry standard ratio is. A quick Google search for your industry will provide this information.

Let’s say your cost of goods sold is $150,000 and your inventory is $80,000.

Example: Discount store

Industry Standard Ratio 4

Cost of goods sold = $150,000 = 1.9

Inventory $80,000

Problem: Your inventory turn over rate is well below your industry average.

Solution: Adding an automated inventory system that tracks how much inventory you have at any given time. So that you don’t buy excess inventory. Understanding inventory management is critical to increasing your sales and increasing your profits!

Hopefully at this point you understand how ratio analysis can improve and help grow your small business.

Finally let’s look at the profit

3. Profitability Ratios- It is a set of financial ratios that measure sales and return on investment

Example: A high end boutique selling high priced items and your target profit margin is > 15% of sales. Your sales for the year are $350,000. Your after-tax net profit is $60,000

Net profit after tax = $60,000 = 17.1%

Sales $350,000

In this example you are 2% above your target profit! You are making money your business is growing and business is good!

As we saw above; Using ratio analysis is a simple, yet effective way to enhance business performance and drive business growth.

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