As a small business owner, you know that tracking your business’s health is vital for its survival and growth. But with the myriad of numbers and data available in your books and financial statements, it can be overwhelming to decide what to focus on. That’s where financial ratios come in. In our daily work as an SEO/SEM and digital marketing consultancy, we use several of these ratios on a regular basis.
Financial ratios are essential tools that offer a deeper understanding of your business’s financial health. They provide insights into your company’s performance by comparing various financial data points. In other words, they help you “read between the lines” of your financial statements, turning raw numbers into actionable information.
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Defining Financial Ratios
Financial ratios are just mathematical comparisons of financial statement accounts or categories. Taken to a higher level, the ratios help investors, creditors, as well as a company’s management understand how well a business is performing and areas of needing improvement.
Financial ratios are also a type of key performance indicator (KPI) and are used exclusively with data from your company’s financial statements. While other KPIs (say, marketing ones) might require data from various sources like website traffic or conversion rates, financial ratios keep it simple by only using the information readily available in your financial statements.
Why Are Financial Ratios Needed?
As a business owner, you’re constantly processing a lot of data. Financial ratios can help you focus on the different aspects of your business – cash flow, efficiency, and profit. You can actually use these ratios to analyze trends, compare your business to competitors, and measure progress towards your company’s finanical goals.
Top Financial Ratios for Small Businesses
While there are many ratios that you can track, some stand out as the most important and practical for small businesses. We have 9 financial ratios in our list that we grouped into 3 overarching categories: liquidity ratios, profitability ratios, and efficiency ratios.
Let’s take a look at these categories and the best financial ratios for small businesses within them:
Liquidity Ratios
Liquidity ratios measure your company’s ability to pay off its short-term obligations using its short-term assets. They provide insights into your company’s financial stability in the short term. Here are two key liquidity ratios to track:
- Current Ratio: This ratio compares your current assets (cash and other assets that are expected to be converted to cash within a year) to your current liabilities (debts a company must pay within a normal operating cycle, usually less than 12 months). A current ratio of less than 1 could indicate potential liquidity problems. Formula: Current Ratio = Current Assets / Current Liabilities
- Quick Ratio: Also known as the acid test, this ratio is a stricter measure of liquidity as it excludes inventory from current assets. It provides a more immediate sense of your business’s short-term financial health. A good quick ratio is anything above 1. A ratio of 1:1 would mean the company has the same amount of liquid assets as current liabilities. A ratio higher than 1 indicates your company could pay off current liabilities several times over. Formula: Quick Ratio = (Cash + Marketable Securities + Accounts Receivable) / Current Liabilities
Profitability Ratios
Profitability ratios measure your company’s ability to generate profit, which is different from just “making money”. There ratios help you understand your business’s bottom line and overall financial performance. Here are 3 key profitability ratios to track.
- Net Profit Margin: This ratio shows how much profit your business makes for every dollar it generates in revenue after deducting all costs. Formula: Net Profit Margin = (Total Revenue – Total Expenses) / Total Revenue
- Gross Margin Ratio: This ratio represents the percentage of total sales revenue that your company retains after incurring the direct costs associated with producing the goods and services sold. Formula: Gross Margin Ratio = (Total Sales Revenue – Cost of Goods Sold) / Total Sales Revenue
- Return on Assets (ROA): This ratio measures how efficiently your company can convert its investment in assets into profits. Formula: Return on Assets = Net Income / Total Assets
Efficiency Ratios
Efficiency ratios measure how effectively your company uses its assets and liabilities internally. Here are 4 key efficiency ratios you could use to track:
- Inventory Turnover Ratio: This ratio measures how quickly your business sells its inventory within a given timeframe. Formula: Inventory Turnover Ratio = Cost of Goods Sold / Average Inventory
- Receivables Turnover Ratio: Also known as Days Sales Outstanding (DSO), this ratio measures how quickly your business collects payments after a sale has been made. Formula: Receivables Turnover Ratio = Net Credit Sales / Average Accounts Receivable
- Cash Flow to Debt Ratio: This ratio can help you monitor your cash flow and anticipate potential liquidity problems. Formula: Cash Flow to Debt Ratio = (Net Income + Depreciation) / Total Debt
- Sales per Employee Ratio: This ratio can help you determine how efficiently your business is operating in terms of your staffing levels. Formula: Sales per Employee = Total Revenue / Total Employees
How to Effectively Use These Financial Ratios
Financial ratios are most effective when used to track trends over time. Single snapshots can provide useful information, but tracking these ratios regularly, at specific intervals, can provide deeper insights and help you anticipate potential issues before they become significant problems for your business.
We keep a spreadsheet where we track our ratios over time. This helps us pull the necessary data from our booking system. Setting it all up took some time, but it’s a useful tracker for us now.
Final Words
Understanding and using financial ratios can provide great insights into your small business’s financial health. These ratios can help you identify potential issues early on and make informed decisions about how you operate and grow your business. Remember, you don’t have to use all of these ratios. The most important financial ratio is the one that helps you understand your business better and make strategic decisions. So use it first!
In our opinion, financial management is not just about tracking income and expenses; it’s about understanding the story those numbers tell and using that story to guide your business decisions. Knowledge is power. The more you know about your company’s financial health, the better equipped you’ll be to make informed decisions and guide your business to success.