Are you struggling to grow your business? How about being confused about your business’s financial health? If so, you aren’t alone as numerous small business owners struggle to measure the success of their business. Financial statement ratios might be the solution to your problem as these metrics provide quick and accurate insight into different areas of your business.
There are five main types of ratios to consider implementing into your monthly or even weekly processes: liquidity, profitability, leverage, efficiency, and market value. Each of these ratio classes analyzes a certain function, making it important to understand the benefits of choosing the right ones to implement.
Liquidity Ratios
Liquidity ratios give insight into working capital, such as how efficient you are with spending your money. Small business owners choose to utilize liquidity metrics to ensure they have enough cash on hand to cover upcoming obligations or to plan for large purchases.
For some background, current assets are liquid items, such as cash, accounts receivable, inventory, and short-term investments, while current liabilities are accounts payable and wages payable. Anything that is either due to you or you expect to pay in the next 12 months is considered current while everything that exceeds the 12-month mark is non-current, such as long-term notes payable or fixed assets. Common liquidity ratios include:
Current Ratio= Current Assets / Current Liabilities
This ratio dives into how well you can cover your upcoming obligations based on the assets you have in the bank. Ideally, this ratio should be above one, indicating you have enough assets to pay suppliers, employees, and vendors.
Quick Ratio= Current Assets – Inventory / Current Liabilities
This ratio is similar to the current ratio; however, inventory is excluded. Some business owners view inventory as an asset that can’t be easily converted to cash. Just like the current ratio, a number above one is considered good while a number below one indicates upcoming cash flow issues.
Profitability Ratios
Another main category of financial statement ratios that business owners see success using are profitability ratios. These ratios focus on how much income or loss your business is generating based on revenue and expense items. Revenue is everything your company earns from customers while expenses remain the costs spent to generate the income. Profitability ratios include:
Gross Margin= Gross Profit / Net Sales
Gross margin is a great ratio for businesses with cost of goods sold, which is everything that goes into the direct creation of your product or service. For example, a construction company would report supply costs and labor in this category. This tells you how profitable your operations are before considering other costs. A negative percentage here indicates that you have lost money before factoring in other general costs, highlighting improvement is needed.
Operating Margin =Operating Income / Net Sales
This ratio takes into consideration selling, occupancy, and general and administrative expenses to give you an overall picture of how profitable you were over a period of time. Just like gross margin, a positive number means you are generating income while a negative number shows you have a loss.
Return on Assets= Net Income / Total Assets
Some businesses run their business with a high level of assets, such as computer equipment, machinery, and vehicles. These businesses should consider utilizing the return on asset calculation to uncover how well assets are at generating income. A poor ratio, which is usually negative, may indicate that more efficient equipment is needed.
Leverage Ratios
Large enterprises aren’t the only ones that benefit from utilizing debt financing. In fact, many small businesses that leverage lines of credit and installment loans see heightened benefits in cash flow management. If you are a business that engages in any type of financing, consider calculating these ratios:
Debt Ratio= Total Debt / Total Assets
Comparing your total debt to your total assets tells you if your debt burden is too high. The acceptable ratio will depend on the industry you operate in and your business needs.
Debt to Equity= Total Debt / Total Equity
This ratio shows your current debt load compared to prior income or loss. Equity includes owner contributions and distributions as well as all the income from prior years. Investors pay close attention to this ratio since it gives insight into how likely they are to recoup their investment if the company goes under.
Efficiency Ratios
Efficiency ratios measure how productive a company is using its working capital components to generate income. The favorability ofyour percentage will be based on if you are calculating the efficiency of an asset or liability. Most commonly current assets or liabilities are calculated using efficiency ratios, including:
Asset Turnover= Net Sales / Average Total Assets
The average asset figure takes the asset total at the beginning of the period plus the asset total at the end of the period and divides that number by 2. Small business owners want to see a higher ratio here, which indicates that the assets are becoming more profitable.
Payable Turnover= Cost of Goods Sold / Average Accounts Payable
This financial statement ratio is the opposite of the asset turnover ratio since it measures your current obligations. The payable turnover calculation tells you how quickly you are paying your suppliers.
Market Value Ratios
The ratios in the market value category aren’t as useful for small business owners who aren’t looking to sell or go public since they focus on earnings per share. Nevertheless, if you are planning on taking your business public or have a high level of investors or shareholders, consider using the following ratios:
Earnings Per Share= Net Earnings / Total Shares Outstanding
EPS shows how profitable each company share is. Investors are more likely to contribute their money to a company that has a high EPS.
Price Earnings Ratio= Share Price / Earnings Per Share
Building off EPS is the price earnings ratio that measures a company’s fair market value of the share price to the current earnings per share. Investors want to see a good balance between these two items.
Deciding on the Right Ratios
The ratios you find useful for your business will depend on your operational goals and industry; however, that doesn’t mean you have to make those decisions on your own. Working with a qualified accountant, like Bookkeepme can make all the difference in not only uncovering the right metrics to track, but also finding viable strategies to implement these strategic goals. Reach out today to set up a consultation.
CFI Team. “Financial Ratios.” CFI, 28 April2022, https://corporatefinanceinstitute.com/resources/knowledge/finance/financial-ratios/.Accessed 29 August 2022.
