Financial Ratios and What They Mean for Newbie Managers

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Some small business owners view accountants as an unnecessary expense. I know this because I used to be one of those small business owners. However, all of that changed when I realised that my business account didn't balance. I realised that I did not have the skills to do the numbers anymore so I called in an accountant and asked him to go over the books. He was a real pro and I decided that I needed him on my team. Since hiring the accountant, I have learnt just how important the work they do can be to a small business.

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Financial Ratios and What They Mean for Newbie Managers

26 October 2018
 Categories: , Blog


One of the responsibilities of top-level management is to make finance-related decisions that will drive the organisation to the next level. You need to understand investments, spending, cashflow, and risk management among other things. This can be difficult for someone who has not taken any finance classes or worked closely with the finance department. You need to get a few tricks up your sleeves by learning jargon such as accounting ratios. Normally, accountants use them to show the position and performance of the firm. Here is a review of various financial ratios to help you understand what they mean for your organisation:

Activity Ratios

Just as their name suggests, activity ratios focus on what goes on in the organisation every day. They examine the current accounts of a company to measure its ability to generate cash from non-cash assets. Accountants often use the following activity ratios to gauge the operational efficiency of a firm:

Total assets turnover ratiothis ratio measures a firm's ability to use its assets to sell its products in the market. Finance gurus divide all the sales by the total assets to determine how well the company is using its assets. High total assets turnover ratios are a good sign, indicating that the firm is holding little inventory to maximise its sales.

Receivables turnover ratio—accounts receivables refer to payments that other people owe your firm. The accounts receivable turnover ratio shows how well the company is managing its debtors by dividing all the credit sales by the amounts receivable over a certain period. Lower ratios suggest poor management of the debt collection process. 

Current Ratio

A current ratio is an important tool for making executive management decisions. The ratio tells you much is available in form of current assets to pay off the current liabilities of a business enterprise. It computes the monetary value of each current asset that you can use to settle short-term debts. Generally, current assets refer to cash or units that the firm can quickly convert into cash. Examples include inventory, prepaid expenses, and accounts receivable.

Current ratios are easy to compute by dividing all the current assets by the current liabilities (liabilities payable within one year) of the firm. Most accountants advocate a current ratio of two, meaning that the firm has two current assets for every one current liability it needs to pay off. However, higher ratios are an added advantage because the business is in a better position to settle its current liabilities.