12 Financial Ratios Every Small Business Owner Should Know

February 8, 2024

Simon Madziar
Simon Madziar

12 Financial Ratios Every Small Business Owner Should Know

Navigating the financial health of a small business can feel like captaining a ship through a storm. Key metrics, known as financial ratios, are the navigational tools that help steer this ship towards calmer, more profitable waters. Understanding these ratios, which can be calculated using a company’s financial statements, is crucial for longevity and success in the small business world.

Which financial ratio is most important for evaluating a company's profitability?

The most important financial ratio for evaluating a company's profitability is the net profit margin. It measures the percentage of revenue that remains as profit after all expenses are deducted. A higher net profit margin indicates better profitability and efficiency in managing costs.

Introduction

For small business owners, entrepreneurs, and sole traders, the ability to interpret financial ratios is not just a skill—it’s an essential part of daily business life. These ratios shed light on the company's financial strength, operational efficiency, and profitability in a given period. This blog post will guide you through the top 12 financial ratios every small business owner should know, helping you make informed decisions for your business’s future.

Liquidity ratios

The liquidity of a business refers to its capacity to meet its immediate financial obligations, including accounts payable, accrued expenses, and short-term debt. In the event of liquidity difficulties, a company may encounter challenges in paying its employees and suppliers, as well as meeting its daily operational expenses, which can result in significant issues. One way to measure a company's liquidity is through liquidity ratios, which use information from the balance sheet and cash flow statement to determine how quickly a company can pay back its short-term debts. One commonly used liquidity ratio is the working capital or current ratio, which compares a company's current assets to its current liabilities. A working capital ratio of 1 or higher indicates that a company's assets exceed the value of its liabilities, providing a good indication of its ability to meet short-term obligations.

Liquidity ratios commonly assess the correlation between a company's existing assets, such as cash, inventory, and receivables, and its current liabilities.

1. Current Ratio

Definition & Significance:

The current ratio measures a company's ability to pay short-term obligations or those due within one year. It is a clear indication of a business’s liquidity.

Current Ratio = Current Assets / Current Liabilities

Calculation & Interpretation:

Calculated by dividing current assets by current liabilities, a ratio above 1 indicates a healthy financial position, whereas a ratio below 1 may signal liquidity issues.

2. Quick Ratio

Definition & Significance:

Also known as the acid-test, this ratio measures the company’s ability to meet short-term liabilities with its most liquid assets.

Quick Ratio = (Cash & Cash Equivalents + Marketable Securities + Accounts Receivable) / Current Liabilities

Calculation & Interpretation:

Calculated by subtracting inventory from current assets, then dividing by current liabilities, it avoids less liquid inventory calculation involved in current ratio.

When your quick ratio exceeds 1, it implies that your business has a satisfactory level of liquid assets to address short-term obligations and sustain ongoing operations.

3. Days of Working Capital

Definition & Significance:

This ratio calculates the number of days that a company will take to convert its working capital into revenue.

Days Working Capital = ((Current Assets - Current Liabilities) x 365) / Revenue from Sales

Calculation & Interpretation:

The formula involves dividing working capital by the average daily operation costs. Lower days suggest a faster turnaround while higher days may indicate potential liquidity issues. This ratio can also be used to compare against industry standards.

Leverage ratios

Leverage signifies the degree of debt within a company's capital structure, comprising both debt and shareholders' equity. A company that exceeds the industry average in terms of debt is classified as highly leveraged.

Embracing a high level of leverage can prove beneficial in certain scenarios. When interest rates are low, a progressive company can leverage this opportunity to capitalise on market prospects. However, it is important to carefully consider the company's high debt levels, as they come with a high level of risk. It is essential, though, for the company to have the financial capacity to comfortably meet its debt obligations. On the other hand, companies that struggle to fulfil their debt payments may face setbacks and find it challenging to secure additional funds to sustain their operations.

4. Debt-to-Equity Ratio

Definition & Significance:

This ratio indicates the relative proportion of shareholders' equity and debt used to finance a company's assets.

Debt to Equity Ratio = (Long-Term Debt + Short Term Debt + Leases) / Shareholders’ Equity

Calculation & Interpretation:

To find it, divide total liabilities by shareholders' equity. A lower ratio usually points to a company with less risk tied to its financial structure.

The ideal debt to equity ratio can differ across industries. Typically, a ratio of approximately 2 or 2.5 is regarded as favourable for most companies. This implies that for every dollar invested by shareholders, around 66 cents is sourced from debt, while the remaining 33 cents is derived from equity.

Nevertheless, companies with steady cash flows may be capable of maintaining a higher ratio without encountering difficulties.

5. Debt to Total Assets

Definition & Significance:

This ratio is used to determine the percentage of a company's assets that are financed by debt.

Debt to Total Assets = Total Debt / Total Assets
Calculation & Interpretation:

Total debts divided by total assets, it indicates how much of a company's assets are funded through borrowing. A higher ratio may suggest higher financial risk for the company. On the other hand, a lower ratio may indicate better financial stability.

Investors generally favour allocating their funds to companies that maintain a debt to total assets ratio below 1. This indicates that the company possesses a greater amount of assets in comparison to its liabilities, thereby enabling it to settle any outstanding debts by selling its assets, if necessary.

Profitability ratios

Evaluating profitability ratios allows you to gauge your effectiveness in generating profit and delivering value to your shareholders. These ratios serve as a valuable tool in understanding your income-generating potential and the impact you have on your shareholders' investments.

6. Net Profit Margin

Definition & Significance:

This ratio shows how much of each dollar earned is translated into profits.

Profit Margin Ratio = Net Income / Net Sales

Calculation & Interpretation:

By dividing net income by sales, this margin assesses the overall efficiency of the business, taking all costs into account.

The ideal profit margin ratio can vary greatly depending on the industry you are in. To effectively evaluate your performance, it is recommended to utilise a database of profit margins specific to your sector and compare your results with those of your competitors.

7. Return on Assets (ROA)

Definition & Significance:

ROA shows how profitable a company is relative to its total assets.

Return on Assets = Net Income / Average Assets

Calculation & Interpretation:

Dividing total net income by total assets, it measures how effectively assets are being used to generate earnings.

A higher ROA indicates that the company is effectively utilising its assets to generate profits, while a lower ROA may suggest that the company's assets are not being used efficiently. This ratio should be compared against industry averages for a more accurate evaluation.

8. Return on Equity (ROE)

Definition & Significance:

Return on Equity (ROE) is a financial ratio used to measure the profitability of a company by evaluating how efficiently it uses shareholder's equity.

Calculation & Interpretation:

Return on Equity (ROE) = Net Income / Average Shareholders' Equity

This metric provides insight into a company's ability to generate profits from the invested funds of its shareholders. A higher ROE is generally preferred, as it indicates that the company is using shareholder funds effectively to generate profits.

However, a consistently high ROE may also indicate a risky financial structure. It is recommended to compare this ratio with other companies in the same industry for a more accurate assessment of performance.

9. Return on Investment (ROI)

Definition & Significance:

ROI measures the gain or loss on an investment relative to its cost.

ROI = ((gain from investment - cost of investment) / (cost of investment)) x 100

Calculation & Interpretation:

Calculated by dividing the return of an investment by the cost of the investment, it helps determine the efficiency of different financial investments for the business. A higher ROI indicates a better return on the investment, while a lower ROI may signify a less profitable venture.

It is important to consider the time frame and cost of the investment when interpreting this ratio, as it may fluctuate greatly depending on these factors.

Asset management ratios

Asset management ratios focus on how effectively a company is managing its assets to generate sales and profits. These ratios provide insight into the efficiency of a company's operations and can be used for benchmarking against industry averages.

10. Inventory Turnover Ratio

Definition & Significance:

This ratio identifies how often a company’s inventory is sold and replaced over time.

Inventory Turnover Ratio = Cost of Goods Sold / Average Inventory

Calculation & Interpretation:

Cost of goods sold divided by average inventory, it’s used to ensure the right inventory levels are maintained.

When assessing your inventory turnover ratio, it is essential to benchmark it against other companies within your industry. A lower inventory turnover ratio in comparison to the industry average may suggest that your sales performance is subpar or that you have an excessive amount of inventory on hand.

11. Accounts Receivable Turnover

Definition & Significance:

This assesses how efficiently your business collects cash from credit sales.

Receivables Turnover = Net Annual Credit Sales / Average Accounts Receivable

Calculation & Interpretation:

With the formula total net sales divided by average accounts receivable, it shows the number of times receivables are collected, on average, during the period.

Evaluating the quality of your receivables turnover ratio requires a careful analysis of how it aligns with your company's credit policies and payment terms. For instance, if your credit terms stipulate a 30-day payment window, but your receivables turnover indicates an average collection period of 45 days, it may indicate issues with extending credit to customers who struggle to pay or a need to enhance your collection procedures.

Exceeding your goals is evident when you have a Net 60 policy, as collecting payments within 45 days demonstrates exceptional performance.

12. Fixed Asset Turnover

Definition & Significance:

This ratio measures how efficiently a company uses its fixed assets to generate revenue.

Fixed Asset Turnover = Revenue from Sales / Net Fixed Assets

Calculation & Interpretation:

A higher fixed asset turnover indicates that the company is effectively utilising its assets to generate revenue. A lower fixed asset turnover may suggest poor management of assets, underutilisation of resources, or a need for investments in new or more efficient equipment.

It is important to compare this ratio with industry standards and the company's historical data to gain further insight into its performance. It can also be used in conjunction with other related ratios such.

Conclusion

Financial Ratios are indispensable elements in the toolbox of a smart entrepreneur. They are not just abstract numbers on a page; they represent real-world implications for your business and can drive your strategic decision-making process.

Regular tracking and comparison of these ratios with industry standards will help maintain financial discipline and inform your strategic direction. If diving into these computations seems daunting, consider seeking out a financial expert's guidance to set you on the right path.

Remember, your goal is not to just run your business but to grow it sustainably. And understanding the language of business through these financial ratios is a sure-fire way to be fluent in success.

Actionable Advice

Incorporate these ratios into a regular review schedule and use them to monitor the pulse of your business. Don't just calculate them; interpret and use the insights they provide. Are you meeting your targets? Do you need to adjust your goals? These are the dynamic questions that will help you understand how much profit your business is making and guide you in making necessary adjustments to maximize your success.

Stay proactive with your finances and let these key financial ratios illuminate the path to better financial management and a wealthier business future.

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