Small business financial ratios: 7 essentials

Consider calculating these simple financial ratios the next time you examine your financial statements.

You may feel a little overwhelmed looking at all of the numbers on your financial statements. When there's a lot of information, it's difficult to focus on what's the most accurate measure of business health. A small business needs to know what financial ratios to track in order to succeed.

Financial ratios are used by investors and banks to evaluate the strength of a company. In addition to external auditors, accountants use them to examine a company's financial statements. For small business owners, they can be just as useful.

Here are the seven key financial ratios for a small business to track, and how to get the most insight from them.

Financial Ratios: What Are They?

Financial ratios can help you manage your business better by turning raw numbers into information. A small business owner may look at gross sales or net income regularly, but those figures can only tell you so much. Ratios provide insight into seemingly insignificant numbers, allowing you to read between the lines.

A financial ratio is a type of key performance indicator (KPI). While you can track a number of KPIs, financial ratios only use information from your financial statements. Other KPIs, such as website traffic and customer satisfaction, may require data from other sources.

Why Measure Financial Ratios?

Your business processes a lot of data. You can use financial ratios to analyze your cash flow, efficiency, and profit. Using them, you can analyze trends, compare your business against competitors, and measure your progress.

A financial ratio simplifies the process of staying on top of your business's health.

1. CASH FLOW TO DEBT

(Net Income + Depreciation) ÷ Total Debt = Cash Flow to Debt Ratio

The cash flow of small businesses is still a problem even when they make money every month. What's the reason? Their cash is largely used for debt repayment. Due to the fact that weak cash flow is one of the main reasons for small business failure, the cash flow to debt ratio can be a useful red-flag indicator.

Debt usually doesn't pose a liquidity problem until the due date. Getting your business off the ground might have required you to borrow money from friends and family. If you don't make payments, you can ignore the looming repayment date. The loan suddenly needs to be repaid and there is no cash flow available.

Keep your eye on cash flow by using the cash flow to debt ratio rather than alienating the people who helped you start your business. Liquidity should increase as you get closer to the maturity date of your loan. A cash flow to debt ratio of less than one indicates that you cannot cover your bills without securing additional funding.

2. NET PROFIT MARGIN

(Total Revenue – Total Expenses) ÷ Total Revenue = Net Profit Margin

Net profit margin is the percentage of revenue left after operating expenses, interest, and taxes have been deducted. The net profit margin shows how well a company manages costs and converts revenue into profits for investors.

Net profit margins are calculated as a percentage of sales. A 10% profit margin means that the company keeps 10 cents from every dollar sold.

Poor net profit margins-or ones that are declining over time-can indicate a number of issues. There may be a problem with customer service causing sales to decline. You may have a problem with employee theft or aren't keeping track of consumable office supplies.

The net profit margin of your products indicates that you have priced them correctly and controlled your costs well.

3. GROSS MARGIN RATIO

(Sales – Cost of Goods Sold) ÷ Total Sales = Gross Margin Ratio

You should pay attention to this ratio if your business sells products. After you pay for the product that you sell, how much money do you have left over to cover your operating expenses (like marketing, salaries, and rent)?

Ratios can be measured by product or by business as a whole. A clothing retailer, for example, can measure gross margin by a product, like jeans, or by clothing overall.

Your gross margin determines the amount of money you have left over to pay for your other business expenses. You may have difficulty paying your operating expenses if you have a low gross margin.

4. QUICK RATIO

(Cash + Marketable Securities + Net Accounts Receivable) ÷ Current Liabilities = Quick Ratio

Any business with current liabilities such as accounts payable, short-term loans, payroll taxes payable, income taxes payable, credit card debt, and other accrued expenses can benefit from the quick ratio (also known as the acid test).

Using this ratio, you can determine whether you have enough current assets to cover your current liabilities (cash, liquid investments, and receivables). Is it possible to keep your business afloat even if you experience a temporary setback?

A quick ratio of 2.0 means that you have $2.00 in liquid assets for every $1.00 of current liabilities. Quick ratios are better when they are higher.

Is it possible for your business to expand without investing cash? The quick ratio is a helpful place to start. When your quick ratio falls below 1.0, your debts exceed your assets. Your first priority should probably be to pay down debt and save more money.

As inventory may not be easily converted to cash, this ratio does not include it in your current assets.

5. ACCOUNTS RECEIVABLE TURNOVER

(Total A/R Outstanding ÷ Total Sales) x Number of days = A/R Turnover

Accounts receivable (A/R) turnover is also known as days sales outstanding (DSO). The length of time it takes for a company to get paid after a sale has been made.

Small businesses struggle with cash flow, and being paid quickly can make the difference between struggling to pay bills and feeling confident in their cash position.

Your receivables process should be improved if your A/R turnover starts getting high.

6. INVENTORY TURNOVER RATIO

Cost of Goods Sold ÷ Average Inventory = Inventory Turnover Ratio

In businesses that carry inventory, the inventory turnover ratio can be useful. An inventory conversion rate tells you how many times inventory has been converted into sales. It can be calculated monthly, quarterly, or annually.

When your inventory turnover ratio is high, you are frequently turning over your inventory. Inventory turnover ratios are higher in businesses with perishable inventory, such as food, than in businesses with non-perishable inventory.

You can determine if you are wasting resources on storage costs or tying up cash on slow-moving or non-saleable inventory by calculating your inventory turnover ratio. A retailer's inventory is often one of its biggest assets, so investors use this to determine how liquid it is. Inventory that cannot be sold is useless to the company.

Since inventory is often used as collateral for loans, creditors frequently use this ratio. Banks want to know that your inventory will be easy to sell before lending you money.

Take a look at your inventory turnover ratio if you are considering additional financing for your business, either through an outside investor or a small business loan.

7. SALES PER EMPLOYEE

Annual revenue ÷ Number of employees = Sales per Employee

What is the cost of running your business? For companies with many employees, such as service-based businesses, sales-per-employee can be a reliable estimate.

An efficient business uses its resources (people) very efficiently if its sales-per-employee ratio is high. Without a lot of employees, you can accomplish a lot.

As your business grows, you should keep an eye on this metric. Have you noticed a drop in your sales-per-employee ratio as you add more employees? Are you able to maintain it at the same level (or higher)?

Your business is operating efficiently if your sales-per-employee grows over time. In the absence of this, you should investigate whether this is a temporary issue (maybe sales slowed for a while but are expected to increase) or if business operations aren't running as efficiently as they should.

Using Financial Ratios Effectively

Financial ratios provide a snapshot of your company at a given moment. To get the most out of your financial ratios, it's wise to look at trends. Rather than calculating the ratios once to determine if they are positive or bad, track and compare them over time.

Keeping a spreadsheet of the ratios you calculate over time is the easiest way to do this. Calculate the ratios every quarter using the information from your accounting system. Over time, this will become easier and faster. It may take a bit of time the first couple of times you do it.

Regularly review your ratios and assess the health of your business. Taking this step early and often can help you avoid negative situations your business may face.