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Should I Be Looking at Financial Ratios?

Dec 10, 2019 8:00:00 AM Cheryl Coyle Small Business, Financial Management

Financial Growth IllustrationRoutinely looking at the financial ratios of your small business will help you reach your goals. Looking at your balance sheet, profit and loss statement, and cash flow is one way to gauge how your business is doing. Reviewing financial ratios is equally important. Ratios are commonly used to make comparisons between different aspects of a company’s performance and how it compares to other companies in the same industry.

Lenders often use financial ratios to determine the stability and health of your business. The balance sheet provides a portrait of what your business owns, or is owed (assets), and what it owes (liabilities). Bankers will often make financial ratios a part of business loan agreements. For instance, you may have to keep your equity above a certain percentage of your debt, or your current assets above a certain percentage of your current liabilities.

But ratios should not be evaluated only when visiting your banker. Ideally, you should review your ratios on a monthly basis to keep on top of changing trends in your company. Although there are different terms for different ratios, they fall into four basic categories.

1. Liquidity Ratios

Liquidity ratios provide a broad look at your financial health. They measure the amount of liquidity (cash and easily converted assets) that you have to cover your debts. Banks are very interested in these ratios should you need a loan. Types of liquidity ratios:

  • Current Ratio: This measures your company's ability to generate cash to meet your short-term financial commitments. Also called the working capital ratio, it is calculated by dividing your current assets, such as cash, inventory, and receivables, by your current liabilities.
  • Quick Ratio: This measures your ability to access cash quickly to support immediate demands. Also known as the acid test, the quick ratio divides current assets (excluding inventory) by current liabilities (excluding current portion of long-term debts). A ratio of 1.0 or greater is generally acceptable, but this can vary depending on your industry.

A comparatively low ratio can mean that your business might have difficulty meeting obligations and may not be able to take advantage of opportunities that require quick cash. You can improve this ratio by paying off liabilities.

A higher ratio may mean that your capital is being underutilized and could prompt you to invest more of your capital in projects that drive growth, such as innovation, product or service development, R&D, or marketing.

What constitutes a healthy ratio varies from industry to industry. For example, a shoe store will have goods that quickly lose value because of changing fashion trends. Still, these goods are easily liquidated and have high turnover. As a result, small amounts of money continuously come in and go out. Even in a worst-case scenario, liquidation is relatively simple.

On the other hand, an auto manufacturer has high-value, non-perishable assets that do not turn over quickly. The current ratio should be much higher to allow for coverage of short-term liabilities.

When cash is tight, chart your quick ratio to see the progress you are making. You will have a sense of accomplishment seeing the ratio improve as you make small changes.

2. Efficiency Ratios

Efficiency ratios give additional insight into areas of your business, such as collections, cash flow, and operational results.

  • Inventory Turnover: This looks at how long it takes for inventory to be sold and replaced during the year. It is calculated by dividing total purchases by average inventory in a given period.
  • Inventory to Net Working Capital Ratio: Determine if you have too much of your working capital tied up in inventory. It is calculated by dividing inventory by total current assets. In general, the lower the ratio, the better.
  • Average Collection Period: This looks at the average number of days customers take to pay for your products or services. It is calculated by dividing receivables by total sales and multiplying by 365. You should also compare your policies to those of your industry to ensure you remain competitive.

3. Profitability Ratios

Profitability ratios are used to evaluate the financial viability of your business and are useful in comparing your business to others in your industry.

  • Net Profit Margin: This measures how much a company earns (usually after taxes) relative to its sales. A company with a higher profit margin than its competitor is usually more efficient, flexible, and able to take on new opportunities.
  • Operating Profit Margin: This measures earnings before interest and taxes. The results can be quite different from the net profit margin due to the impact of interest and tax expenses. By analyzing this margin, you can better assess your ability to expand your business through additional debt or other investments.
  • Return on Assets (ROA) Ratio: This tells how well management is utilizing the company's various resources (assets). It is calculated by dividing net profit (before taxes) by total assets. The number will vary widely across different industries. Capital-intensive industries will yield a low return on assets since they need expensive infrastructure to do business. Service-based operations such as consulting firms will have a high ROA, as they require minimal hard assets to operate.
  • Return on Equity (ROE): This measures how well the business is doing in relation to the investment made by its shareholders. It is calculated by dividing a company’s earnings after taxes by the total shareholders’ equity and multiplying the result by 100%.

A cross-sectional analysis is a common tool for profitability ratios. This analysis compares the ratios of several companies from the same industry. For example, your business may have experienced a downturn in its net profit margin over the last two years. However, if your competitors have experienced a larger average downturn, your business is performing relatively well.

4. Leverage Ratios

Leverage ratios provide an indication of the long-term solvency of a company and to what extent you are using long-term debt to support business activities.

  • Debt-to-Equity & Debt-to-Asset Ratios: These are used by banks to see how your assets are financed, whether it comes from creditors or your own investments. Generally, a bank will consider a lower ratio to be a good indicator of your ability to repay your debts or take on additional debt to support new opportunities.

Interpreting Ratios

Ratios vary from industry to industry and over time. Interpreting ratios requires knowledge of your business and your industry. It's important to keep in mind that ratios are only one way to determine your financial performance. We can assist you in learning more about your financial health. Contact us to find out how.

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Cheryl Coyle

Written by Cheryl Coyle