Financial ratios are the tools that small business owners can use to gauge the performance of their operations. You can benchmark these ratios and track their trends to identify non-performing areas and take corrective actions.
Here are the financial ratios that you may consider following to manage your business.
Profitability Ratios
Gross profit: This is the profit margin you make from the production of your products and services. To find the gross profit, subtract the cost of goods sold – which includes direct labor costs and materials – from total sales. Your business must produce enough gross profit to pay overhead expenses and leave an adequate net profit.
Net profit: The net profit, or bottom line, is the final profit a company makes after paying all of its expenses.
Liquidity Ratios
Liquidity ratios measure the company's ability to meet its short-term obligations.
Current ratio: The most common metric used to measure liquidity is the current ratio. You can calculate this ratio by dividing current assets by current liabilities. A good current ratio is to have $2 in current assets for each $1 in current liabilities.
Quick ratio: A stricter measure of liquidity is the quick ratio, also known as the acid-test ratio. This calculation only includes a company's cash plus accounts receivable divided by its current liabilities. A quick ratio less than 1 to 1 would mean that a company doesn't have enough liquidity to meet its short-term obligations.
Consider also: What Do Financial Ratios Tell You?
These comparisons will show you which areas in your business are performing well and those that are not and need attention.
Efficiency Ratios
A company makes more profits by using its assets effectively. Efficiency ratios show how well a company is turning over the investments in its assets.
Inventory turnover: The faster a company can sell its merchandise and turn over its inventory, the better. Managers track their inventory turnover ratio to weed out slow-selling items and minimize the number of funds invested in inventory.
Accounts receivable turnover: After the merchandise is sold, the goal is to collect the receivables and use the cash to purchase more inventory. The accounts receivable turnover is found by dividing total sales made on credit terms by the average amount of receivables outstanding.
Leverage Ratios
Companies need an adequate amount of equity capital to fund their operations and survive during periods of economic downturns. Higher amounts of debt increase a company's financial risk.
Debt-to-equity ratio: The debt-to-equity ratio measures a company's degree of financial leverage and reveals its vulnerability to decreases in sales and lower profits. A well-capitalized small business would have $1 in debt for each $1 in equity.
Interest coverage: Companies need adequate cash flow to cover interest and principal payments on debts. The interest coverage ratio is calculated by dividing a company's earnings before deductions for interest and taxes (EBIT) by the annual interest charges. This ratio should be above 2 to 1 for a comfortable level.
Consider also: How to Calculate Financial Risk
Comparisons to Industry Averages
After calculating these ratios for your business, you can compare the results to the average of other companies in your industry. These comparisons will show you which areas in your business are performing well and those that are not and need attention.
For example, if your gross profit margin is 36 percent and the industry average is 44 percent, this would be a signal that you need to look at either your pricing strategy, maybe to increase prices, or the costs related to production, perhaps you have material being wasted.
The same comparison analysis could be made with all the other financial ratios to identify the under-performing areas of your business.
Consider also: What Are Industry Trends?