Your business’ financial statements are made up of a whole lot of numbers, and seeing them all at once can quickly become overwhelming. That’s why we’ve developed a short-list of the 5 key financial ratios every small business should monitor so that you can quickly navigate the vast amounts of information on your financial statements and focus on the key metrics that speak to you about your business’ health.
Effectively, financial ratios help you derive insight from the various numbers that are presented on your financial statements, or are already being recorded within your accounting system. These insights can help you make better business decisions, and allocate your resources more effectively. While looking at total figures such as gross sales or net income are helpful, financial ratios can help draw lines and analysis between various different metrics to provide you with the ‘story behind the numbers’.
Also check out our blog post on How to Determine Key Performance Indicators.
1. Quick Ratio
(Cash + Marketable Securities + Net Accounts Receivable) ÷ Current Liabilities
This ratio indicates whether you have enough current assets (cash, or assets that can be readily converted to cash, such as liquid investments, and accounts receivable) to cover your current liabilities (liabilities that need to be paid within the upcoming year such as accounts payable, short-term loans, payroll taxes payable, income taxes payable, credit card debt, and other accrued expenses).
Having a quick ratio higher than 1.0 means that you have more than $1.00 in liquid assets available to cover each $1.00 of current liabilities. Effectively, the higher this ratio, the greater your buffer against unexpected liabilities that need to be settled.
Conversely, having a ratio lower than 1.0 means that your debts are greater than your assets, and this can indicate that you need to build up the cash reserves in your business to improve the financial health of your business, of if you want to invest cash in expanding your business.
2. Net Profit Margin
(Total Revenue – Total Expenses) ÷ Total Revenue
This ratio indicates the percentage of your revenue that’s left over after deducting all of the operating expenses of your business. It effectively tells you how much of each dollar that your business generates in revenues gets converted into profits. For example, a 12% net profit margin means that 12 cents of every dollar of revenue is profit for the business.
Having a high net profit margin means that you are pricing your products correctly and exercising good cost control. The higher this ratio, the more successful and efficient your business is.
Conversely, having a lower margin (when compared to previous periods) means that your business operation costs are increasing (which could be for a variety of reasons including inventory spoilage or theft) or sales are decreasing (either due to lower demand, defective products, or poor customer service), or perhaps both. You’ll need to analyze both the revenue and expense components of your business to determine why profitability has been affected.
3. Accounts Receivable (A/R) Turnover
Net Credit Sales ÷ Average A/R
This ratio indicates how good your business is at getting paid what it is owed from a sale. Effectively, it tracks the amount of time it takes your business to be paid once a sale has been made.
For example, let’s say your business had $100,000 in net credit sales for the year, with average accounts receivable of $25,000. The A/R turnover in days would be 4, calculated by dividing the credit sales, $100,000, by the average accounts receivable, $25,000. This indicates that the business is collecting average receivables 4 times per year, or once per quarter.
Having a high A/R turnover ratio means that your company is in a good cash flow position, its collection policies are robust, and that your customers’ debts are being paid quickly. However, having an unusually high A/R turnover ratio could indicate that your credit policies are too aggressive, resulting in upset customers, or missed sales opportunities from dependable customers with slightly lower credit scores.
Conversely, having a lower ratio could mean that your customer’s debts are getting stale and that collection may be an issue for your business. It could also mean that customers aren’t paying because they may not be getting satisfactory service, or there may be error or malfunctions in the products or service which need to be rectified.
4. Cash Flow to Debt
(Net Income + Depreciation) ÷ Total Debt
This ratio indicates how big your company's cash flow from operations are in relation to its total debt. Effectively, it allows you to gauge how long it would take your business to repay its debt if it devoted all of its cash flow to debt repayment.
Having a high cash flow to debt ratio means that your business is in a strong financial position and is able to accelerate its current debt repayments if necessary.
Conversely, having a lower ratio (when compared to previous periods) means that your business may be at risk of not being able to make its interest payments without securing additional funds, and is comparably not as healthy from a debt repayment perspective.
5. Return on Investment (ROI) Ratio
(Gain from Investment - Cost of Investment) ÷ Cost of Investment
This ratio indicates how much your business has benefitted from an investment you made, allowing you to determine which investments were successful and which weren’t. Essentially, it compares how much money an investment brought in relative to how much you paid for it. You can calculate this ratio for individual investments, or across a portfolio of investments.
Having a high ROI ratio means you received more income per investment, whereas a lower ROI might mean the investment was not as profitable. However, it is also crucial to assess each investment’s non-financial benefits as well, as some projects may be required regardless of the monetary return it would provide (such as helping make a process more efficient, or because it may complement another investment you have made).
BONUS RATIO: Inventory Turnover Ratio
Cost of Goods Sold ÷ Average Inventory
This ratio indicates you how many times inventory was transformed into sales during a specific time period (such as over a month, quarter, or year). Essentially, it helps you determine how liquid your inventory is.
A high inventory turnover ratio means that your business is able to successfully sell your inventory frequently, thus indicating your business model’s overall health, and a strong consistent demand for the products or services you are selling. This may also help secure funding from lenders and banks as they usually want to know that your inventory isn’t sitting unsold for long periods of time.
Conversely, having a lower ratio means that you may be wasting resources on inventory storage costs, or you have a stockpile of slow-moving or non-salable inventory.
Using Financial Ratios Effectively
Calculating financial ratios at any given time will provide you with a snapshot of your company at that particular moment. However, to utilize financial ratios to their full advantage, track and compare them over time to see the trends, and determine if they are improving or deteriorating in the long run.
Many popular accounting programs available today, such as QuickBooks, allow you to create custom reports where you can gather all the information you need. You can then export these into a separate spreadsheet where you can calculate the ratios every month, or quarter.
Over time, you can review these ratios and assess the overall health of your business. You can also benchmark your ratios against competitors in your industry to determine where you stand. Keep in mind that you should try to compare your financial ratios against businesses your own size and within your own industry so that you can draw relevant and realistic insights.
Schedule a meeting
At Arria CPA, we work with our clients to prepare timely Compilation Financial Statements packages, which includes a management report outlining all 5 Key Financial Ratios (and other Key Performance Indicators!) to help them understand the financial landscape of their business. We also schedule a year-end review meeting to discuss your business’ performance and activities during the year, allowing you to ask questions and clarify any confusing items. Also included is a detailed management letter outlining your upcoming tax liability and filing responsibilities, and any other concerns identified during the financial statement compilation process.
Contact us for a free, no-obligation consultation to learn more about how Arria CPA can help prepare and review these key financial ratios for your business this upcoming year-end.
Disclaimer: Please note that this is only a brief summary and is based on current accounting regulations and tax law interpretations. Accounting regulations and tax laws are subject to continual review and change, so should the facts provided to us be inaccurate or incomplete, or should the law or its interpretation change, our summary may be inappropriate for your uses. This article is written for educational purposes only, and as such, we recommend you consult a professional before making an accounting or tax decision. If you have any concerns, or would like further consultation regarding this matter, please contact us.
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