What Financial Ratios Are Used to Measure Business Risk?

Monday, 5 Jul 2021

Running a business in Melbourne is packed with facing challenges and taking risks. A miscalculated business risk can have a significant impact on the financial stability of the company and can sometimes even lead to bankruptcy. There are a variety of risks associated with a business, including financial risks, compliance risks, operational risks, and international risks.

Thus, most entrepreneurs rely on professional bookkeepers in Melbourne to take calculated risks that do not threaten the sustainability of the company. Since risks are inevitable while operating a business, it is a sensible decision to measure the risk before going forward. For example, the entrepreneur should not take a huge amount of debt, which is unmanageable and can lead to payment defaults and penalties.

A bookkeeper can help in this regard by offering advice on the feasible amount of loan for a business. Here is a list of the financial ratios that are used by bookkeeping companies and professionals to measure business risks.

 What are Financial Ratios?

Financial ratios are measurement tools that provide information about the financial health of the company. The ratios aid the bookkeeper in analysing the performance of the company in its industry or location.

These are helpful in offering details of debts, receivables, and inventory so that the business owner is aware of the losses incurred through these sources. The ratios are also examined by investors and moneylenders in Melbourne when applying for funding or loans. There are five types of financial ratios that are used to measure business risks. Let us look at them.

1. Debt-to-Capital Ratio

This ratio is utilised for understanding the financial standing of a business. It is calculating by comparing long-term and short-term debts with the total capital received from shareholder’s equity and debt financing. It determines the capacity of the company in Melbourne to pay back the debt. The formula used by bookkeepers is as follows:

Debt-to-Capital Ratio = Long-Term Debt + Short-Term Debt / Total Debt + Equity

If the amount calculated from this ratio is lower, it displays that the business is not dependent on the debts and is capable of managing its running expenses. A higher debt-to-capital ratio indicates that the business has borrowed a lot of money, and thus, is at a higher risk of financial instability. However, it can also work in favour of the business in Melbourne if it is able to use the debt for growth and higher profits.

 2. Debt-to-Equity Ratio

Similar to the debt-to-capital ratio, the debt-to-equity ratio also provides an insight into the capability of the business to repay its debt. However, it offers a direct approach by comparing debt financing with equity financing. The formula used by bookkeepers is as follows:

Debt-to-Equity Ratio = Long-Term Liabilities + Current Liabilities / Equity

Current liabilities are short-term obligations of a business in Melbourne, including salaries, payments to suppliers and taxes. Entrepreneurs who do not invest time and effort in tax planning make the worst bookkeeping mistake, which can be harmful to the business.  

Here, again a lower ratio specifies that the company is in control of its finances and can repay its debts as it is not completely dependent on the loan amounts for survival. It also indicates that the business can withstand small financial troubles or economic turbulences without needing to borrow additional funds. A higher debt-to-equity ratio is considered unhealthy for the business and may not get the required funding from moneylenders in Melbourne.      

3. Current Ratio/ Liquidity Ratio

The liquidity ratio is calculated by bookkeepers to determine the ability of the business to pay off its short-term liabilities, which are due within the next year. It informs about the short-term liquidity of the business on the basis of the current assets and the outstanding liabilities. Current assets are those assets that can be liquidated within a short period. The formula is as follows:

Current Ratio = Current Assets/ Current Liabilities

If the current liabilities are higher than current assets, the current ratio is less than one, which indicates that the business may not be able to fulfil its short-term liabilities. On the other hand, if the current ratio is more than 1, it implies that the company in Melbourne is well positioned to pay its short-term debts.

4. Quick Ratio

It is another way of calculating short-term risks besides the current ratio, with just one change. It does not include inventory in current assets because liquidating inventory can take time and may not be completed in short-term. The formula is as follows:

Quick Ratio = Current Assets – Inventory / Current Liabilities

5. Solvency Ratio

Calculating the solvency ratio is a part of the plethora of tasks covered by bookkeeping. It determines the long-term sustainability of the business and indicates if it can manage its liabilities. The formula is as follows:

Solvency Ratio = Net Profit Tax + Depreciation / Current Liabilities + Long-Term Liabilities

A lower solvency ratio implies that the business Melbourne will not be able to pay off its debt liabilities in the long run. It should be above 20% to represent a healthy financial status. However, the number may change for different industries. Your bookkeeper can help you in reaching a positive figure so that you will not default on your debt payments in future.        

 Conclusion

Business owners must seek the advice of their bookkeepers in Melbourne to calculate the financial ratios that help them to measure the risks. These are needed to make informed investments and get the funding that can be repaid without any defaults.     

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