Investors and banks use financial ratios to judge the strength of a business. They’re also used by financial auditors who want insight into a company’s financial statements. However, they can be just as useful for small business owners. We’ll share why.
Simply stated, financial ratios are tools that can turn your raw numbers into information to help manage your business better. Many small business owners look at gross sales or net income on a regular basis, but those figures can only tell you so much. Financial ratios help you read between the lines, providing insight from seemingly inconsequential numbers.
Financial ratios are useful indicators of performance and financial situation. They can be used to analyze trends, compare your business to competitors and measure progress towards goals. They may seem unfamiliar at first, but they’re simply comparisons between specific numbers pulled from your accounting reports. Don’t feel intimidated if you haven’t dealt with financial ratios before. Once you give them a try, you will see that they actually aren’t very difficult to calculate nor complicated to use. The next time you take a look at your financial statements, consider taking a few minutes to calculate these simple financial ratios.
1. Cash Flow to Debt
(Net Income + Depreciation) ÷ Total Debt = Cash Flow to Debt Ratio
Small businesses make money every month, but still have cash flow problems. Why? Much of their cash is going towards debt repayment. This is where the cash flow to debt ratio can be a useful red-flag predictor—since weak cash flow is the main reason for small business failure.
Debt usually doesn’t materialize as a liquidity problem until its due date. Maybe you borrowed money from a friend or family member to get your business up and running. As long as you’re not making payments, it can be easy to ignore that looming repayment date. All of a sudden you need to repay the loan and you don’t have the cash flow to do it.
Rather than risk alienating the people who were generous enough to help you get your small business off the ground, use the cash flow to debt ratio to keep an eye on cash flow. The closer you get to the maturity date of your loan, the higher your liquidity should be. A cash flow to debt ratio less than one is a sign that you cannot cover your bills without securing additional funds.
2. Quick Ratio / Acid Test
(Cash + Marketable Securities + Net Accounts Receivable) ÷ Current Liabilities = Quick Ratio
The quick ratio (also known as the acid test) is useful for any business with current liabilities such as accounts payable, short-term loans, payroll taxes payable, income taxes payable, credit card debt and other accrued expenses. This ratio measures your liquidity, telling you whether you have enough current assets (cash, liquid investments and accounts receivable) to cover your current liabilities. Can you keep your business afloat even in the face of a temporary setback?
Having a quick ratio of 2.0 means that you have $2.00 in liquid assets available to cover each $1.00 of current liabilities. The higher the quick ratio, the better your position. Wondering whether you can afford to invest cash in expanding your business? The quick ratio is a good place to start. If your quick ratio is less than 1.0, your debts are greater than your assets. You should probably work on paying down debt and saving more cash first.
Note: This ratio does not include inventory in your current assets, as inventory may not be readily converted to cash.
3. Net Profit Margin
(Total Revenue – Total Expenses) ÷ Total Revenue = Net Profit Margin
Net profit margin is the percentage of your revenue remaining after deducting all operating expenses, interest, and taxes. Many investors look at net profit margin because it shows how successful a company is at managing costs and converting revenue into profits.
A poor net profit margin—or one that is declining over time—can be an indication of a variety of problems. Maybe sales are decreasing due to poor customer service. Perhaps you’re not doing a good job of keeping tabs on consumable office supplies, or maybe you have an employee theft problem.
A high net profit margin indicates that you are pricing your products correctly and exercising good cost control. Generally, a net profit margin of more than 10% is good, although it can vary by industry.
4. Gross Profit on Net Sales
(Net Sales – Cost of Goods Sold) ÷ Net Sales = Gross Profit on Net Sales
Gross profit on net sales is a useful ratio for sellers of goods. It calculates whether your average markup normally covers your expenses, resulting in a profit. A gross profit that is consistently lower than your average margin is a signal that something is wrong. Perhaps you’re pricing your products too low or you need to look for ways to control your product costs.
It’s a good idea to calculate this ratio on a regular basis—perhaps monthly or quarterly. A downward trend could signal future problems for your bottom line. Give yourself the chance to correct your course before the damage is done by recognizing the issue sooner than later.
5 . Inventory Turnover Ratio
Cost of Goods Sold ÷ Average Inventory = Inventory Turnover Ratio
As the name implies, the inventory turnover ratio is useful for businesses that carry inventory. It tells you how many times inventory was converted to sales during a time period. You can calculate it by month, by quarter or by year.
A high inventory turnover ratio indicates that you are turning your inventory over frequently. Companies with perishable inventory, such as food, will have a higher inventory turnover ratio than businesses with more expensive, non-perishable inventory.
Calculating your inventory turnover ratio can help you determine if you are wasting resources on storage costs or tying up cash on slow-moving or non-salable inventory. Investors frequently use this to determine how liquid a company’s inventory is since inventory is often one of the biggest assets a retailer reports on its balance sheet. It’s worthless to the company if the inventory cannot be sold. Creditors also frequently use this ratio since inventory is often marked as collateral for loans. Before lending money, banks want to know that your inventory will be easy to sell.
If you are considering obtaining additional financing for your business, either through an outside investor or a small business loan, take a look at your inventory turnover ratio and improve that number if it needs work.
The financial ratios that are relevant to your business will depend on the type of business you are in, whether you carry inventory, have cost of goods sold, use debt, or have depreciable assets. Select what makes sense for you and consider using them as your key performance indicators (KPIs). Tracking these KPIs over time can help you identify potential issues or let you know when strategic changes you make to your business have the desired effect.
Check your KPIs monthly or quarterly. Learning how to measure and interpret your own financial data is a vital part of being a responsible and, ultimately, successful business owner.
Janet Berry-Johnson is a CPA and a freelance writer with a background in accounting and insurance. Her writing has appeared in Forbes, Parachute by Mapquest, Capitalist Review, Guyvorce, BonBon Break and Kard Talk. Janet lives in Arizona with her husband and son and their rescue dog, Dexter. Outside of work and family time, she enjoys cooking, reading historical fiction, and binge-watching Real Housewives.