Financial Ratios and How to Use Them in Small Businesses

What are Financial Ratios?

Running a business, whether large or small, means that having a good grasp on all financial aspects that are part of ensuring business success is essential.

One of the best ways to determine the business’ financial performance is through financial ratios. Financial ratios are numerical values that measure the relationship between two or more components, which is determined by using the data found on a business’s financial statements, such as the balance sheet, income statement, and cash flow statement.

These values will help determine a range of ratios that will discover things, such as a business’s profitability, liquidity, operational efficiency, and solvency, which are essential to understanding and optimising business performance.

What are Financial Ratios Used For?

For companies and businesses, financial ratios are often used to present easy-to-understand information to investors or banks and financial institutions.

This helps external parties grasp the financial status of a business when requesting funding from an investor or applying for loans. And it’s not just for companies that operate on a large scale. Financial ratios are important for small businesses as well, especially start-ups looking for investor funding or needing to be granted a financial loan.

Financial ratios are also important for internal business processes. These ratios are useful for conducting analyses that provide meaningful data about a business and its financial stability. It can help track performance, identify any financial difficulties, save money and help set goals and KPIs and show future earnings.

Over time, keeping track of these values can help identify trends that show how the business is performing and its financial position. For example, monitoring the debt to asset ratio over time will help prevent the business from becoming at risk of default. They can also help with comparing the business benchmarks to other competitors and industry averages. This is especially relevant for new businesses or those in competitive industries.

What Do Financial Ratios Measure?

Financial ratios measure the profitability, liquidity, operational efficiency, and solvency of a business. Examples of these ratios are listed below.

Profitability Ratios

Profitability can be defined as the measure of a business’s profit compared to its expenses. The efficiency of a business is related to its profitability. Financial ratios that measure profitability are listed below. The numerical values needed for the profitability ratios are found on the business income statement. 

Gross Profit Margin Ratio

Having a gross profit margin with a higher value shows that the product or service being sold is being converted into a profit. This financial ratio requires knowing two numerical values: the total cost of producing the product/service, including labour and materials — cost of goods sold — and net sales, which is the revenue, minus returns and discounts.

Gross Profit Margin = net sales – cost of goods sold/net sales x 100

Net Profit Margin Ratio

A net profit margin with a higher value means that the business converts sales into a profit. The net profit of a business is determined by deducting all operating, tax, and interest expenses from the amount of money earned.

Net Profit Margin = net profit/sales x 100

Operating Profit Margin Ratio

Higher operating profit margins show that the business has efficient management and a good ratio of operating costs. Knowledge of a business’s gross profit is required for analysing this profit ratio. This is calculated by subtracting all manufacturing and operating expenses from the revenue.

Operating Profit Margin = gross profit – operating expenses/revenue x 100

Return on Equity Ratio

This financial ratio is for investors and calculates the rate of return on investments they will receive from their equity in the business.

Return On Equity = net profit/shareholder’s equity

Liquidity Ratios

The following ratios refer to accounting liquidity, which is the ability of a business to turn current assets into cash or the ease at which they could pay off any short-term obligations. The data required to analyse these ratios would be found on the balance sheet and cash flow statement. A ratio greater than 1 shows good measures of liquidity.   

Working Capital/Current Ratio

This ratio is to determine if a business’s assets exceed its financial liabilities and thus its ability to pay off short-term liabilities. 

Working Capital Ratio = current assets/current liabilities

Cash Ratio

This ratio is a similar measurement to a working capital ratio, but only measures cash and cash equivalents that do not include inventory. 

Cash Ratio = cash & cash equivalents/current liabilities

Quick Ratio or Acid-Test Ratio

The quick ratio measures how well a business can turn current assets into cash in order to pay outstanding debts. 

Quick Ratio = current assets – inventory – prepaid expenses/current liabilities

Cash Flow to Debt Ratio 

This ratio determines if a business’s operating cash flow suffices to pay off any business liabilities. The operating cash flow calculation is total revenue – operating expenses

Cash Flow to Debt Ratio = operating cash flow/current liabilities

Operating Cash Flow to Net Sales Ratio

This number should stay consistent as sales increase as it measures how much cash the business can make in relation to its sales.

Operating Cash Flow to Net Sales = operating cash flow/net sales

Free Cash Flow to Operating Cash Flow Ratio

A high free cash flow is desired by shareholders and a higher ratio means financial stability for the business. Free cash flow is calculated by cash from operations – capital expenditures.

Free Cash Flow to Operating Cash Flow Ratio = free cash flow/operating cash flow

Operational Efficiency

These ratios determine how effectively a business is using its assets and resources.

Revenue per Employee

Measures effectiveness of employees in relation to revenue.

Revenue per Employee = annual revenue/annual number of employees

Return on Total Assets

Measures the ability to generate sales from assets.

Return on Total Assets = net income/net total assets

Inventory Turnover

Measures the efficiency of the business’s ability to sell and replace inventory.

Inventory Turnover = cost of goods sold/average inventory

Accounts Receivable Turnover Ratio 

Measures the rate of collections. A higher ratio means customers are paying more quickly.

Accounts Receivable Turnover = net annual credit sales/average accounts receivable

Solvency or Leverage Ratios

Solvency measures the business’s ability to pay any long-term debt. Values from the balance sheet are used for these ratios.

Debt to Equity Ratio 

Shows the business’s ability to pay off any loans. 

Debt to Equity Ratio = total liabilities/shareholder’s equity

Debt to Asset Ratio

This ratio measures how many of a business’s assets are financed from loans. A high ratio could indicate financial trouble. 

Debt to Asset Ratio = total liabilities/total assets

Still, Confused? 

There is good news. While these analyses are important to running a successful business, they can be automated by using business accounting software. Talk to a local accountant or, for those based in Australia, you could speak to a professional albany accountant at The Accounting Centre for more information on financial ratios, get taxation help or about help in business overall! 

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