Are you just getting your feet wet as a small business owner? Or are you a seasoned business owner looking to take your firm to the next level? Regardless of your experience running a business, financial ratios can help you examine your company’s financial status and make more educated business decisions based on data and statistics.

 

There are dozens, if not hundreds, of financial measures to keep track of. So, which are the most crucial for you? In this blog post, we’ll share details of the ten financial ratios we think are the most important.

Why do small business owners need to monitor financial ratios?

Financial ratios are significant because they allow business owners to compare their financial performance to that of similar companies in their trade.

Your balance sheet, income statement, and cash flow statement are all beneficial, but they only provide a limited amount of information. Financial ratios demonstrate how effectively your firm funds itself, makes a profit, grows through sales, and manages expenses beyond the numbers. They can also serve as an early warning sign if something isn’t functioning, allowing business owners and managers to make changes.

Which financial ratios are most essential?

There are dozens of financial ratios to keep track of, but the most relevant ones are described below:

Liquidity Ratios

Liquidity is a metric that measures your company’s capacity to meet short-term obligations like accounts payable, accrued expenses, and short-term debt. When a firm is experiencing liquidity issues, it may have difficulty paying employees and suppliers, as well as covering other everyday running expenses, resulting in major issues.

Current assets (cash, inventory, and receivables) are generally compared to current liabilities in liquidity ratios.

• Current Ratio

Your current ratio, which can also be referred to as working capital ratio, is an indication of your ability to meet short-term obligations, such as liabilities and debts that are due within a year.

Current Ratio: Current Assets / Current Liabilities

If your current ratio is greater than one, this indicates that you can pay for all payables, accrued expenses, and short-term debts using your current assets.

• Acid test ratio

Your acid test ratio is a measure of your company’s capacity to pay its obligations, comparable to the current ratio. However, rather than looking at all current assets, it simply looks at the company’s most liquid assets (cash, marketable securities, and accounts receivables). Prepaid expenses are excluded because they cannot be used to pay other short-term liabilities, and inventory is excluded because it may take too long to convert into cold hard cash.

Quick ratio: (Cash & Cash Equivalents + Marketable Securities + Accounts Receivable) / Current ratio

An acid test ratio greater than one indicates that your company has sufficient liquid assets to meet short-term obligations and maintain operations.

3) Working capital days

The number of days it takes to turn your working capital into sales is called working capital days.

Days of Working Capital: ((Current Assets – Current Liabilities) x 365) / Revenue from Sales

A high days of working capital figure indicates that it takes your organisation longer to turn its working capital into cash. Because they have the ability to use working capital efficiently, companies with smaller days working capital require less funding.

Comparing your results to those of other companies in the same industry is the greatest method to assess how healthy your days of working capital figure is.

Leverage Ratios

The amount of debt in your company’s capital structure, which includes both debt and shareholders’ equity, is referred to as leverage. A corporation that is highly leveraged has more debt than the industry average.

Being heavily leveraged is not always a bad thing. Low loan rates may be used by a growing company to take advantage of market possibilities. As long as the company can comfortably make debt payments, being highly leveraged could be a sensible business option. Companies that have difficulty making debt payments, on the other hand, may fall behind and be unable to borrow further funds to stay afloat.

4) Equity to debt ratio

To determine the riskiness of a company’s financial structure, the debt to equity ratio compares total debt to total equity. Lenders and other creditors keep a close eye on this measure because it might indicate when a company is taking on too much debt and is having problems meeting payment obligations.

Debt to Equity Ratio: (Long-Term Debt + Short-Term Debt + Leases) / Shareholders’ Equity

The definition of a good debt-to-equity ratio varies by industry. For most businesses, a ratio of roughly 2 or 2.5 is considered good. That indicates that 66 cents of every dollar invested in the company comes from debt, while the remaining 33 cents comes from equity.

Companies with continuous cash flows, on the other hand, may be able to maintain a greater ratio without running into issues.

While you’re here…

Running a small business is not without risk. Many small business owners invest their own money, as well as their time, talent, and energy, into their projects. They generate significant money for the economy by creating jobs and providing crucial services.

Small business insurance exists to assist these businesses in managing their risks and filing claims for losses when things go wrong. Take the time to research the policies that are applicable to your business and industry today.To learn more about business insurance, click here.

5) Debt to assets ratio

The percentage of your company’s assets financed by creditors is known as the debt to total assets ratio.

Debt to Total Assets: Total Debt / Total Assets

Companies with a high debt-to-total-assets ratio are riskier to invest in because they must pay out a bigger percentage of their profits in principle and interest payments than companies with a lower ratio.

Most investors prefer to invest in companies with a debt-to-total-assets ratio of less than one. This indicates that the corporation has more assets than liabilities and, if necessary, has the ability to pay off its debts by selling assets.

Profitability Ratios

The ability to generate income (profit) and create value for shareholders is measured using profitability ratios.

6) Profit Margin Ratio

The amount of net income earned per dollar of sales generated by the company is measured by your net profit margin ratio. In other words, it displays what percentage of sales remains after all company expenses have been paid.

Profit Margin Ratio: Net Income / Net Sales

A decent profit margin ratio varies by industry; thus, using a database of profit margins by sector can be useful.

7) Return on Assets

By comparing your profits to the amount you’ve put in assets, you have the ability to determine how well your company is operating. The bigger the return on investment, the more effectively you may use your financial resources.

Return on Investment: Net Income / Average Total Assets

While comparing your ROA against that of other companies in your industry is useful, looking at how your return on assets varies over time is even more so. If this indicator rises year after year, it means you’re extracting more profit from each dollar of assets on your balance sheet. If your ROA is decreasing, it could indicate that you’ve made some poor investments.

8) Return on Investment

The ability of a corporation to create profits from shareholder investments is measured by its return on equity (ROE).

Return on Equity: Net Income / Shareholders’ Equity Equals Return on Equity

A decent return on investment is determined by your industry. Electronics businesses, for example, have a ROE of over 44 percent, while engineering and construction companies have a ROE of just over 6 percent, according to the NYU Stern School of Business.

Asset management Ratios

Asset management ratios look at how well a business utilises its assets to create revenue. Businesses that carry inventory or sell to clients on credit typically adopt the following ratios.

9)  Inventory Turnover Ratio

The efficiency with which you manage inventory is measured by your inventory turnover ratio.

Inventory Turnover Ratio: Cost of Goods Sold / Average Inventory

Compare your inventory turnover ratio to other companies in the same industry. When compared to the industry norm, a low inventory turnover ratio can suggest either weak sales or too much inventory.

10. Receivables Turnover

Receivables turnover refers to how rapidly you collect credit sales.

Receivables Turnover: Receivables Net Annual Credit Sales / Average Accounts Receivables

Comparing your KPIs to your company’s credit standards and payment terms will help you determine whether your receivables turnover ratio is excellent or problematic. If your credit terms allow customers to pay invoices within 30 calendar days, but your receivables turnover shows that payments are taking an average of 45 days to collect, you may have a problem extending credit to customers who are unable to pay, or you may need to tighten up your collection processes.

If you have a Net 60 policy, however, collecting money within 45 days signifies you’ve met your targets.