Home » 10 Essential Financial Ratios for Small Business Owners
Whether you’re a budding business owner or an experienced entrepreneur seeking to elevate your company’s growth, monitoring financial ratios can be crucial for assessing your organization’s financial health and guiding more informed decision-making.
With a multitude of financial ratios available for tracking, selecting the most relevant ones for your business can be overwhelming. This article aims to streamline your decision-making process by highlighting the key ratios to focus on.
Financial ratios are your secret weapon for unlocking valuable insights into your business’s financial performance that go way beyond what standard financial statements can tell you. They also help you see how well you’re doing compared to similar businesses in your industry. Sounds intriguing, right?
Sure, balance sheets, income statements, and cash flow statements can be informative, but they only scratch the surface. Financial ratios dive deep into the heart of your company’s financials, revealing how well you’re doing at self-funding, turning a profit, boosting sales, and keeping expenses in check. Plus, they can even act as an early warning system, giving you a heads up when it’s time to shake things up.
Now, there are countless financial ratios out there, but the real game-changers can be grouped into four key categories:
Curious to know more? We’re about to explore 10 must-know ratios across these categories, complete with detailed explanations to help you master the art of financial analysis. Get ready to level up your business insights!
Think of liquidity as your company’s financial safety net. It’s all about how easily your business can handle short-term obligations like accounts payable, accrued expenses, and that pesky short-term debt. If your liquidity game isn’t strong, you might find yourself struggling to pay employees, suppliers, or cover daily operating costs – and nobody wants that!
Liquidity ratios help you understand how well your current assets (think cash, inventory, and receivables) stack up against current liabilities.
The current ratio, or working capital ratio, gives you a snapshot of your ability to pay off short-term obligations—debts and liabilities due within a year.
Current Ratio = Current Assets / Current Liabilities
Aiming for a current ratio higher than one is a good rule of thumb. That means you’ve got enough current assets to cover every dollar owed for payables, accrued expenses, and short-term debts.
The quick ratio, also known as the acid test ratio, is like the current ratio’s speedier sibling. It measures your business’s ability to pay its debts, but it only considers the most liquid assets (cash, marketable securities, and accounts receivables) and leaves out all other current assets. Why? Because prepaid expenses can’t be used to pay other short-term liabilities, and inventory might take too long to turn into cash.
Quick Ratio = (Cash & Cash Equivalents + Marketable Securities + Accounts Receivable) / Current Liabilities
If your quick ratio is above 1, your business has enough liquid assets to cover short-term obligations and keep things running smoothly.
Days working capital tells you how long it takes to turn your working capital into sales.
Days Working Capital = ((Current Assets – Current Liabilities) x 365) / Revenue from Sales
A high days working capital number means it takes your company longer to get cash from its working capital. Companies with lower days working capital don’t need as much financing because they’re pros at using working capital efficiently.
To get the most out of your result, compare it with other companies in your industry. That way, you’ll know if you’re ahead of the pack or need to up your liquidity game!
Leverage is all about balancing debt in your company’s capital structure, which is made up of both debt and shareholders’ equity. Companies with more debt than the industry average are considered highly leveraged – but don’t panic just yet!
Being highly leveraged isn’t always a bad thing. Savvy companies might use low interest rates to seize market opportunities and fuel growth. As long as your company can comfortably make debt payments, being highly leveraged could be a strategic move. But watch out – companies that struggle with debt payments might find it hard to borrow more money and stay afloat.
The debt to equity ratio measures the riskiness of your company’s financial structure by comparing total debt to total equity. Lenders and creditors keep a close eye on this number – it’s like an early warning system for companies taking on too much debt and potentially struggling with payment obligations.
Debt to Equity Ratio = (Long-Term Debt + Short Term Debt + Leases) / Shareholders’ Equity
What’s a good debt to equity ratio? It depends on your industry. For most companies, a ratio around 2 or 2.5 is considered healthy. That means for every dollar shareholders invest, about 66 cents come from debt and the remaining 33 cents from equity.
But don’t forget – companies with consistent cash flow may be able to handle a higher ratio without breaking a sweat.
The debt to total assets ratio shows you what percentage of your company’s assets are financed by creditors.
Debt to Total Assets = Total Debt / Total Assets
Investing in companies with high debt to total assets ratios can be risky – these companies need to pay a larger chunk of their profits toward principal and interest payments compared to similar-sized companies with lower ratios.
Most investors prefer companies with a debt to total assets ratio below 1. This indicates the company has more assets than liabilities and could pay off its debts by selling assets if necessary. Now that’s a reassuring safety net!
Profitability ratios help you evaluate how good your business is at generating income (profit) and creating value for shareholders.
The net profit margin ratio shows how much net income you earn for each dollar of sales. In simpler terms, it’s the percentage of sales left after covering all business expenses.
Profit Margin Ratio = Net Income / Net Sales
A good profit margin ratio depends on your industry, so it’s smart to compare your results with competitors. Check out databases like the NYU Stern School of Business for profit margin benchmarks by sector.
Return on assets (ROA) tells you how well your company is doing by comparing profits to the capital invested in assets. The higher the ROA, the better you’re using your resources.
Return on Assets = Net Income / Average Total Assets
Comparing your ROA to industry peers is helpful, but tracking changes over time is even more insightful. If your ROA is rising year over year, you’re getting more profits from each dollar of assets. But if it’s declining, you might have made some not-so-great investments.
Return on equity (ROE) measures your company’s ability to generate profits from shareholder investments.
Return on Equity = Net Income / Shareholders’ Equity
A good ROE depends on your industry. For example, the NYU Stern School of Business found that, in 2021, electronics companies averaged an ROE of around 44%, while engineering and construction companies hovered just above 6%.
Asset management ratios reveal how efficiently a company uses its assets to drive sales. These ratios are especially useful for businesses that carry inventory or sell to customers on credit.
The inventory turnover ratio shows how well you’re managing inventory.
Inventory Turnover Ratio = Cost of Goods Sold / Average Inventory
Compare your inventory turnover ratio with industry peers. A low ratio might indicate weak sales or too much inventory.
Receivables turnover measures how quickly you collect payments for credit sales.
Receivables Turnover = Net Annual Credit Sales / Average Accounts Receivable
To determine if your receivables turnover ratio is good or bad, compare it to your company’s credit policies and payment terms. If your terms allow for 30-day payments but it’s taking you 45 days to collect, you might need to tighten up credit or collection processes.
On the flip side, if you have a Net 60 policy and you’re collecting payments within 45 days, you’re exceeding expectations. Go, you!
To wrap things up, let’s face it: diving into the complex realm of financial ratios can feel overwhelming. But fear not! Teaming up with a chartered professional accountant can be your secret weapon.
For businesses in Ontario, KK CPA is the go-to choice. With our squad of financial wizards, we’ll transform the way you understand and analyze your financial performance. We’ll help you conquer the world of ratios, unlocking your business’s true potential. So, team up with KK CPA, and get ready to confidently tackle financial challenges and seize golden opportunities, catapulting your business towards unparalleled success!