The next time you take a look at your financial statements, consider taking a few minutes to calculate these simple financial ratios.
Looking at all of the numbers on your financial statements can be a little overwhelming. There’s a lot of information and sometimes it’s difficult to focus on what the best measures are for your business health. That’s where knowing the best financial ratios for a small business to track comes in.
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 cover exactly what a financial ratio is, the seven best financial ratios for a small business to track, and how to get the most insight out of your financial ratios.
- What Is a Financial Ratio?
- Why Measure Financial Ratios?
- The Best Financial Ratios for Small Businesses to Track
- 1. Cash Flow to Debt
- 2. Net Profit Margin
- 3. Gross Margin Ratio
- 4. Quick Ratio
- 5. Accounts Receivable Turnover
- 6. Inventory Turnover Ratio
- 7. Sales per Employee
- The Best Way to Use Financial Ratios
- Don’t Forget About KPIs, Here’s What You Need to Know (VIDEO)
What Is a Financial Ratio?
Simply stated, financial ratios are tools that can turn your raw numbers into information to help you 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 a type of key performance indicator (KPI). While there are a number of KPIs you can choose to track, financial ratios only use information that can be found on your financial statements. Some other KPIs may use data that you need from other sources, like website traffic and customer satisfaction scores.
Why Measure Financial Ratios?
There is a lot of data that you’re processing as a business owner. Financial ratios can help you focus on the different health aspects of your business—cash flow, efficiency, and profit. They can be used to analyze trends, compare your business to competitors and measure progress towards goals.
Essentially, financial ratios make it easier to stay up-to-date on your business health.
The Best Financial Ratios for Small Businesses to Track
There are a lot of ratios that you can track, but to keep from getting overwhelmed, you should stick to tracking a shortlist of ratios. These are the ratios you’ll want to have on that shortlist:
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 a 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 of less than one is a sign that you cannot cover your bills without securing additional funds.
2. 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.
The net profit margin measures how much profit remains from each dollar in sales. So a 10% profit margin means that 10 cents of every dollar sold the company keeps as profit.
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.
3. Gross Margin Ratio
(Sales – Cost of Goods Sold) ÷ Total Sales = Gross Margin Ratio
If your business sells products, this is a ratio you should pay attention to. How much money do you have remaining to pay for your operating expenses (like marketing, salaries and rent) after you pay for the product that you sell?
This ratio can be measured by product or in total for your business. For example, if you’re a clothing retailer, you can measure gross margin by a product, like jeans or for clothing overall.
The higher your gross margin, the more money you have remaining to pay for your other necessary business expenses. A low gross margin signals that you may have trouble paying your operating expenses.
4. Quick Ratio
(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.
5. Accounts Receivable Turnover
(Total A/R Outstanding ÷ Total Sales) x Number of days = A/R Turnover
Also known as days sales outstanding (DSO), accounts receivable (A/R) turnover measures how good your company is at being paid. That is, how long it takes for a company to be paid once a sale has been made.
Cash flow is a challenge for many small businesses, and being paid quickly can mean the difference between a business struggling to pay bills or feeling very confident in its cash position.
If your A/R turnover starts getting high, it’s a sign that you should spend time working on your receivables process.
6. 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.
7. Sales per Employee
Annual revenue ÷ Number of employees = Sales per Employee
How expensive is your business to run? Sales-per-employee can be a good estimate for companies that need a lot of employees, like service-based businesses.
If your sales-per-employee ratio is high, that means your business is very efficient with how it uses its resources (people). You can do a lot of business without having too large a staff.
This is a useful metric to keep an eye on as your business grows. As you add more employees, is your sales-per-employee ratio taking a dip? Or are you able to keep it at the same level (or higher)?
If your sales-per-employee is generally growing over time, your business is operating efficiently. If it’s not, it’s time to look into whether this is a temporary issue (perhaps sales slowed down for a period but are going to increase) or if your business operations aren’t operating as efficiently as they could.
The Best Way to Use Financial Ratios
Financial ratios show a snapshot of your company at a single moment in time. That’s helpful, but to make the most of your financial ratios, it’s best to look at trends. Track and compare the ratios over time, rather than calculating them once to try and determine if the results are good or bad.
The easiest way to do this is to keep a spreadsheet of the ratios you calculate over time. Every quarter, get the information that you need from your accounting system and calculate the ratios. This may take a little time the first couple of times you do it, but over time it will become easier and faster.
Set aside time to regularly look at your ratios and assess the health of your business. Doing that early and often can help you plan for and possibly avoid negative situations your business may experience.
Don’t Forget About KPIs, Here’s What You Need to Know (VIDEO)
This post was updated in May 2020.
about the author
Erica Gellerman is a CPA, MBA, content marketing writer, and founder of The Worth Project. Her work has been featured on Forbes, Money, Business Insider, The Everygirl, and more. She currently lives in Hawaii.