As a small business owner, understanding and monitoring key financial ratios is crucial for making informed decisions and ensuring the long-term success of your venture. Financial ratios provide valuable insights into your company’s profitability, liquidity, efficiency, and overall financial health.
By analyzing these ratios, you can identify strengths, weaknesses, and areas for improvement, enabling you to take proactive measures and stay ahead of potential challenges. In this post, we’ll explore 10 essential financial ratios that every small business owner should be familiar with.
Why Financial Ratios are Important
Financial ratios are important because they give business owners a way to evaluate financial performance beyond just looking at financial statements. They allow for comparison to similar businesses in the same industry.
While balance sheets, income statements, and cash flow statements provide raw financial data, they offer only limited insight on their own. Financial ratios go deeper by revealing how efficiently a company is funding itself, making profits, growing sales, and managing expenses. They can also provide warning signs if things aren’t working properly, alerting owners and managers when changes need to be made.
Categories of Key Financial Ratios
There are dozens of potential financial ratios to track, but the most important ones fall into four main categories:
Liquidity Ratios
Liquidity ratios measure a company’s ability to pay its short-term obligations and debts as they come due. Key liquidity ratios include:
- Current Ratio = Current Assets / Current Liabilities
- Quick Ratio = (Cash + Marketable Securities + Accounts Receivable) / Current Liabilities
A current or quick ratio above 1 is generally considered healthy, indicating the business has enough liquid assets to cover upcoming liabilities.
Leverage Ratios
Leverage ratios evaluate the degree to which a company is utilizing borrowed money. The primary leverage ratio is:
- Debt-to-Equity Ratio = Total Liabilities / Total Shareholders’ Equity
A lower debt-to-equity ratio implies the company is more financially stable and less reliant on debt financing. However, a higher ratio can allow for potentially higher returns on investment.
Profitability Ratios
Profitability ratios assess a company’s ability to generate profits from its operations and investments. Common profitability ratios include:
- Gross Profit Margin = (Revenue – Cost of Goods Sold) / Revenue
- Net Profit Margin = Net Income / Revenue
- Return on Assets (ROA) = Net Income / Total Assets
- Return on Equity (ROE) = Net Income / Shareholders’ Equity
Higher profit margins and returns signal a company is pricing, controlling costs, and utilizing assets/equity efficiently to drive earnings.
Asset Management Ratios
Asset management ratios analyze how productively a company is utilizing its assets to generate sales revenue. For businesses with inventory, key asset ratios are:
- Inventory Turnover Ratio = Cost of Goods Sold / Average Inventory
- Receivables Turnover Ratio = Net Annual Credit Sales / Average Accounts Receivable
Comparing these ratios to industry averages can identify potential issues with excess inventory levels or slow collections on credit sales.
Wrapping it All Up
By calculating and tracking financial ratios over time, small business owners can spot risks before they escalate and make operational adjustments to improve profitability and financial health.
Now that you understand the importance of monitoring key financial ratios for your small business, it’s time to take action. The Morrison Firm offers expert financial analysis and advisory services from our team of small business accountants to help you calculate and interpret your company’s ratios. Our experienced CPAs and business consultants can provide personalized guidance on improving profitability, liquidity, efficiency, and overall financial health.
Don’t leave your business’s performance to chance. Contact The Morrison Firm to schedule a comprehensive financial review. Take control of your numbers and set your business up for long-term success. Call us today at (903) 251-5100 or click here to get started.
Further Reading:
https://www.investopedia.com/financial-ratios-4689817
https://corporatefinanceinstitute.com/resources/accounting/profitability-ratios
