Financial ratios turn a business’ raw numbers into insightful information that can help determine and manage its financial health. As a small business owner, you can use your ratios to determine your firm’s ability to effectively manage its assets and liabilities and pay off both short-term and long-term debts. You can also use your ratios to analyze trends, compare your product offering to competitors, and measure progress toward goals.
There is a range of financial ratios that companies often calculate, measure, and track. Usually, ratios are not examined alone but are analyzed alongside other performance indicators.
Here are some of the crucial financial ratios used to assess business performance:
Cash flow is crucial for the smooth running of every venture. The ratios help you track the current state of your assets and liabilities and identify areas where to accelerate the cash flow cycle. Some of the common cash flow ratios include:
Current ratio. The current ratio examines the company’s ability to pay off liabilities using current assets. The higher your current ratio is, the greater the likelihood of meeting your financial obligations in the near future.
Quick ratio (current assets – inventory or current liabilities). Also known as the asset test, a quick ratio is a good indicator of the business’ short-term liquidity. It measures how many times liquid assets can pay down your debt. For your financials to be healthy, the quick ratio should be between 1.5 and 2.0
Account receivable days. AR days indicate the average number of days it takes for your firm to collect due payments from your clients. The ideal number of AR days may differ from one firm to another. However, 45 days is typically considered the limit. The higher the number, the bigger the risk of cash flow problems in the future.
Leverage ratios track your business’ debt compared to other metrics like equity or assets. They measure your ability to pay long-term debts. Here are some of the leverage ratios to know:
Debt to equity. This ratio tracks your business’s ability to service current debts so that you can determine whether it is safe to assume additional debts. Usually, lenders prefer a debt-to-equity ratio of 2 to 1 when reviewing business loan requests.
Debt to an asset. This ratio compares your company’s assets to your total debt. A higher debt-to-asset ratio is considered a sign of financial insecurity since most of your overall assets are from liabilities like commercial loans.
Interest coverage ratio. An interest coverage ratio shows the interest your company owes on its unpaid debt. You can calculate this by dividing your earnings by the interest payments due within a specified period.
As the name suggests, profitability ratios track the company’s ability to turn a profit within a specified time. It measures how much income your company can generate after operating costs, debt payments, and the deduction of taxes. The following are some of the profitability ratios that potential investors look at:
Gross profit margin. This is how much your company makes as a percentage of sales. The percentage shows how your profit compares to the cost of production. To find your gross profit margin, deduct the costs of goods your business sold from the net sales amount.
Operating profit margin. Unlike gross profit, this ratio considers your expense, thus giving you more realistic data on your company’s profitability. To find your operating profit margin, deduct your operating expenses from the gross profit.
Earnings before EBITDA (interest, taxes, depreciation, and amortization). This ratio reveals your company’s net profits before factoring in elements such as interest, taxes, and depreciation. The number is then divided by net sales to get your EBITDA margin. Since it offers the most accurate picture of your company’s profitability, the EBITDA margin is a crucial measurement that potential investors look at.
Whether you are a seasoned entrepreneur or just starting out, tracking your financial ratios helps you determine your company’s true financial position so you can make more informed business decisions. With so many financial ratios, it can be challenging to determine the ones you should frequently calculate and track. Experts recommend that you focus on areas of your venture that are currently the highest priority.
If you need more information or assistance to measure your ratios, contact Foster Financial CPA today. We combine our expertise, experience, and professionalism to give each client tailor-made solutions. Contact us today to schedule a consultation.
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