What are Financial Ratios, and Why Are They Important?

Financial ratios are vital metrics formulated from business financial statements that serve to provide meaningful insight into the business. The numbers on a business's financial statements, including cash flow statements, income statements, and balance sheet statements, are utilized to analyze and assess several vital aspects of a business qualitatively. These aspects include profitability, leverage, margins, rates of return, growth, and valuation (most important for selling your business at the highest possible price).

Financial ratios are essential since they serve several key purposes. First, they provide valuable business insights. Analyzing financial ratios will offer vital information on the performance of a business. This information is helpful to management, investors/shareholders, financial institutions, and vendors. A potential buyer will consider business insights before purchasing, including liquidity, debt and asset management, and profitability.

Looking at financial ratios over a number of periods helps with trend analysis. Tracking notable changes in the values of financial ratios is important to track emerging trends in a business. For instance, a debt-to-asset ratio that’s increasing  indicates a business's debt burden and the eventuality of defaulting risk.

Financial ratios also help with competitive business comparisons. You can use financial ratios to compare the performance of your company performance against competing organizations. Comparing key financial ratios against major competitors enables you to analyze how your business performs relative to average industry performance.

For instance, a return on assets ratio analysis between businesses can help a buyer determine the business which is using its assets most efficiently. A potential buyer and commercial business broker will conduct a thorough comparative analysis with other options in your industry to get the best value out of a business for sale. As a seller, you must take note of these metrics if you seek to land the highest possible price on the sale of your business.

The Most Important Financial Ratios to Consider Before Selling

1. Profitability Ratios

Profitability ratios help a business owner understand the company’s profitability which will help to negotiate the best price with potential buyers. The most important profitability ratios to consider when selling your business include:

• Gross Margin – Also referred to as the gross profit margin ratio, it indicates how well you utilize your business assets to generate profit. It is useful for pricing decisions.
• Net Profit Margin – Indicates the earnings percentage against the percentage going back into business operations.
• Return on Investment – Evaluates your business investments' potential return or performance.



2. Financial Leverage Ratios

Financial leverage ratios help analyze the amount of capital sourced from debts to determine how well your business utilizes and manages debt. Financial leverage ratios are crucial metrics for potential buyers to be eligible for business financing. These ratios include:

• Debt to Asset Ratio – This is a measure of the business assets financed by debt rather than business equity. It determines the total business debts relative to the assets the business owns. Potential buyers use this metric to gauge how financially stable a business is. The higher the ratio, the more economically risky it will be to purchase the company.
• Debt to Equity Ratio – This is a measure of the relative proportion of the shareholder’s equity and debt utilized to finance the assets of a business.
• Working Capital – This is a measure of liquidity indicative of whether a company can pay current obligations. It is the relative proportion of the existing current assets of a business to its current liabilities.

Conclusion:

Overall, a sustainable business needs effective financial management and planning. If you are a business owner planning on selling your business, it's crucial to conduct a thorough analysis of your financial data to determine the true worth of your business.

This process can be daunting and cumbersome. It is advisable to enlist the services of a reputable business broker who will advise you on how to sell a business. Financial ratios constitute vital information that entrepreneurs looking to buy a company will analyze to evaluate the purchase.

Contact us today to learn more about the process of selling your business, and how we can help.