Understanding key financial ratios and what they say about your business’s health is an important part of managing your business finances.
Financial ratios are tools that can help you (as well as potential investors and creditors) analyze your business’s financial activities, liquidity, growth, and profitability. They can help you make informed decisions about your business operations and how you invest and spend your money in the future. And you don’t need an accounting degree to understand them.
You can get the numbers to use for financial ratios from your business’s financial statements, including your balance sheet, cash flow statement, and income statement. But once you calculate these ratios, they can provide a bit more insight than those reports offer on their own.
Here’s a look at six of the most important financial ratios for small businesses.
1. Working Capital Ratio
What it is: One key financial ratio you may want to calculate is the working capital ratio, also called the current ratio. It’s a measurement of whether your company can easily pay short-term liabilities with its current assets.
Why it matters: If you apply for a small business loan, a lender may want to see your working capital ratio because it measures your business’s financial health and can tell them how great a risk your company presents as a borrower. For investors, it’s important to understand the liquidity of your company so they can determine how easy it might be for your business to cover debts and get to profitability.
How to calculate: The working capital ratio formula is
Current assets / Current liabilities
You’ll find the numbers you need to calculate this ratio on your balance sheet. Current assets and liabilities are usually those expected to be used or settled, respectively, within the year.
Too low a ratio indicates that you have more liabilities than assets and might be a risky investment. But a ratio that’s too high might suggest that you have money sitting in the bank, not being used to grow the company. A good working capital ratio is generally considered to be between 1.2 and 2.
Example: To take a simplified example, let’s say you own a small toy store. By way of current assets, you have $25,000 in inventory. By way of current liabilities, you owe $10,000 on a business credit card and $5,000 in other short-term debts. That means your total current liability is $15,000. To figure out your working capital ratio, you divide $25,000 by $15,000 to get 1.67.
2. Debt-to-Equity Ratio
What it is: Another financial ratio that can help you better understand your business’s liabilities and assets is the debt-to-equity (also known as debt/equity ratio). This is a measure of your company’s debt in relation to equity (or investment).
Why it matters: Your debt-to-equity ratio indicates how much risk your business runs when it comes to paying back your long-term debt. While taking on debt can help you grow your company, it shouldn’t end up costing you more than the potential growth it creates. Investors typically want to work with companies that aren’t stretched too thin because those are risky investments.
How to calculate: The debt-to-equity ratio formula is
Total liabilities / equity (or investment)
If your company has investors, you use equity for the bottom half of the equation. If it doesn’t, you use the investment that you yourself have made in your company. In terms of debt, only long-term debt (debt being repaid over more than a year) is considered.
The lower the ratio, the less risk your company presents to investors. A ratio of less than 1.0 is typically considered good.
Example: Imagine you have a small bakery. It has an outstanding business loan on which it owes $10,000 plus $5,000 that it owes on a business line of credit. It doesn’t have any shareholders, but you invested $35,000 to get the business off the ground. To find your debt-to-equity ratio, you would divide $15,000 by $35,000 to get a debt to equity ratio of 0.43.
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3. Gross Profit Margin
What it is: Another basic financial ratio you may want to look at is gross profit margin. It’s an indicator of how much profit you’re seeing after you’ve covered your cost of goods sold. Cost of goods sold (COGS) means all the direct costs that go into creating your product, including raw materials, inventory, and labor.
Why it’s important: You may have different profit margins for different products, but your business’s overall gross profit margin looks at all of them together to determine how well you’re using that profit in your company. Put another way, your gross profit margin is a measure of how profitable your company is.
How to calculate: The gross profit margin formula is
Net sales / (Net sales – COGS)
This ratio is generally multiplied by 100 and expressed as a percentage
To find your gross profit margin, you’ll first need to know your cost of goods sold, as well as your net sales.
A higher number is typically viewed as better than a lower number, but what constitutes a good gross profit margin varies by industry. Manufacturers of electrical equipment, for instance, average a gross profit margin of 35%. Grocery stores, on the other hand, average a gross profit margin of 25% to 30%.
Example: Let’s say your small business’s net sales are $10,000 a month. Additionally, we’ll imagine that it cost you $5,000 in direct costs to make your inventory for a month. To calculate your gross profit margin:
(10,000-5,500) / 10,000 =
5,500 / 10,000 = 0.5
Multiplying this by 100, we arrive at 50%.
4. Cash Ratio
What it is: Cash ratio paints a picture of your company’s liquidity. It looks at cash and cash equivalents (assets that can be quickly transferred into cash, like savings accounts) as well as current liabilities (debts due within the year) to demonstrate how easy it would be for your company to pay off all its liabilities without liquidating assets.
Why it matters: Creditors care about your cash ratio because it tells them the value of your current assets that could, if necessary, be converted into cash to cover liabilities. It’s a fairly conservative financial ratio compared to others because it only considers cash or cash-equivalent assets and not other assets like accounts receivable or real estate.
How to calculate: The cash ratio formula is:
(Cash + cash equivalents) / Current liabilities
In general, a higher ratio is deemed better than a lower one since it suggests that the company can probably pay off its debt with relative ease. While there’s no official cutoff, a ratio above 0.5 to 1.0 is generally thought to be good.
Example: Let’s imagine you own a bakery. It has $10,000 in a business checking account, plus $12,000 in equipment and supplies. It also has short-term business debt amounting to $10,000 plus a mortgage on the building the business is in for $150,000. To figure out your cash ratio you would divide $10,000 by $10,000, giving you a ratio of 1.0. (Remember, you’re only dealing with short-term debt and assets you can easily and quickly transfer into cash to pay it off. Therefore the mortgage, which is long-term debt, and the equipment and supplies, which may not be easy to turn into cash, don’t factor into the equation.)
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5. Inventory Turnover Ratio
What it is: If you sell products, this is a useful ratio because it looks at how quickly your company sells and turns over inventory each year.
Why it matters: You may have some products that aren’t selling well, and this calculation will direct you to the ones that you might want to stop making in favor of more popular (and profitable) products. The higher your inventory turnover ratio, the higher your sales volume.
How to calculate: The inventory turnover ratio formula is
Cost of goods sold / Average inventory
You may want to compare inventory turnover from one point in time to another and then average the inventory costs from the beginning and end of that period.
A higher number is generally considered better than a lower one, since it suggests a high turnover rate for your product. But what number is specifically considered good varies by industry.
Example: For the year 2020, your small fan production company has a COGS of 100,000. Your average inventory for the year amounts to $25,000. To find your inventory turnover ratio, divide $100,000 by $25,000. Your ratio is 4.0.
6. Fixed Asset Turnover Ratio
What it is: In your business, you have what are called fixed assets. These are assets like commercial property, machinery, equipment, and commercial vehicles. These fixed assets should be helping you make more money. And that’s what the fixed asset turnover ratio calculates: how well you’re leveraging these fixed assets to increase your revenues.
Why it matters: A low fixed asset turnover ratio may indicate that your company has over-invested in fixed assets that aren’t generating an appropriate amount of revenue.
How to calculate: Here’s the formula for fixed asset turnover ratio
Net sales / Average fixed assets
A higher rate is usually seen as better, as it suggests that your business is getting value from its fixed assets. However this ratio can vary enormously, so there’s no one yardstick to measure what a good fixed asset turnover ratio is. The ratio may be most useful when you’re comparing your company’s use of its fixed assets over time or when you’re comparing your company against its industry as a whole.
Example: If your small business pet toy company had net sales in 2020 of $150,000 and had an average fixed asset total of $50,000 (that you’d invested in machinery), your fixed asset turnover ratio would be 3.0.
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What Is Ratio Analysis?
You and your potential investors can use financial ratios to analyze the data in your financial statements and glean information that goes beyond what those statements tell you straight out. This is called financial ratio analysis.
Typically, you’d use spreadsheet or ratio analysis software to calculate the financial ratios most important to you on a quarterly basis. You can compare the ratios you get with the last quarter or with the same quarter in previous years to spot trends.
Sometimes, it may be helpful to compare your ratios to those of other companies in your industry. That can help you gain a good understanding of your company’s performance. You may want to run analyses on several types of financial ratios to get the full picture of your business’s financial wellbeing.
As the owner of your company, you’ll want to stay on top of your financial ratio analysis. If you have a financial manager or investors, they may also want access to this data on your key financial ratios.
How and When to Conduct Analyses
Using financial ratios can be helpful if:
• You want a snapshot of your business’s performance. This could be because you just want a benchmark or because you’re considering a big move like selling the company.
• You’re looking to take on investors or apply for a business loan. In these cases, your investors or creditors may request certain financial ratios to determine how much of a risk your company presents to them.
• You’re curious about where your business stands in relation to others in your industry.
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Pros and Cons of Working With Financial Ratios
Using financial ratios can help you make better decisions about the future of your business and how it uses capital. Being able to look back at your company’s performance over time can give you (and investors) a good sense of its general financial wellbeing and predict future growth. If the numbers haven’t been good, you can make decisions that put the business back on course for success.
Pros of Working With Financial Ratios
You may also be able to identify trends when you compare your business’s ratios from one time period to another. For example, if Q4 ratios are always positive, it could be an indicator that sales tend to be particularly high that quarter, and you can plan to leverage that fact accordingly.
Calculating your business’s financial ratios and then comparing them to those of others in your industry can give you an understanding of where your company fits among its peers.
And if you’re looking to bring on an investor, having these financial ratios available gives him or her a clear understanding of what kind of risk your company represents as an investment.
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Cons of Working With Financial Ratios
On the other hand, financial ratios don’t always account for economic conditions. If there’s been a period of inflation, comparing numbers from one period to another may not paint an accurate picture, and the same thing is true if there’s a period of economic decline.
Additionally, it can be trickier than you’d think to compare your ratios to industry numbers. Many companies may be tempted to fudge their ratios to make their businesses look more successful than they are, so it may be challenging to get a real apples-to-apples comparison.
The Takeaway
No matter why you’re considering your financial ratios, congratulations. You’re one step further in owning your business’s financial wellbeing. The more you know about your finances, the better informed you are to make decisions to help your company grow over time and to attract investors as a lucrative investment.
If you’re seeking financing for your business, SoFi is here to support you. On SoFi’s marketplace, you can shop and compare financing options for your business in minutes.
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