When it comes to identifying what you need for the long-term success of your business, where’s the first place you look?
We’ve worked alongside countless business owners over the years, and whether they’re self-made entrepreneurs, or MBA grads, the answer is always the same: financial health.
But how do you identify your company’s financial strengths and weaknesses? There are, obviously, many ways to approach the problem, but we find that financial ratio analysis is a simple and straightforward way to identify those strengths and weaknesses.
In this article, we will discuss:
- What a financial ratio is
- Why you should look at financial ratios
- How to know if you have a good financial ratio
- 7 important financial ratios for small businesses
What is a Financial Ratio?
Financial ratios measure a business’s liquidity, profitability, and efficiency. The data used in these can be found on a company’s financial statements. There are several types of financial ratios serving different purposes for small business owners.
Why Look at Financial Ratios?
They are really useful tools for business owners – even if sales and profits are both growing.
Being diligent, even when times are good, will keep you aware of non-obvious risk areas for your small business that may cause problems down the road. Financial ratio analysis allows you to discover areas of concern before they become a problem.
How Do You Know If You Have a Good Financial Ratio?
With some financial ratios, there are numbers that are typically good for a business.
With others, a good number is highly dependent on your industry and business model. For example, a good net profit margin for a SaaS company is different from a good net profit margin for a restaurant.
But in any case, comparing your numbers to your peers’ is an excellent starting point for evaluating your financial health.
Also, track and evaluate the long-term trends of your financial ratios. If your numbers improve over time, that’s a good thing.
7 Important Financial Ratios for Small Businesses
1. Working Capital Ratio
The working capital ratio – sometimes referred to as the current ratio – compares a business’s current assets against its current liabilities.
Working Capital Ratio = Current Assets / Current Liabilities
So, a business with $40,000 in current assets and $20,000 in current liabilities has a working capital ratio of 2 ($40,000/$20,000).
A working capital ratio between 1.5 and 2 is ideal for many small businesses. This means the small business owner has more than enough current assets to cover current liabilities when they come due – but not so much that they have excess cash that could be used to pursue growth opportunities instead.
2. Quick Ratio
The quick ratio compares a business’s more liquid assets (those expected to be turned into cash within 90 days) against its current liabilities.
Quick Ratio = (Cash + Cash Equivalents + Marketable Securities + Accounts Receivable) / Current Liabilities
Here’s how the quick ratio would be calculated for a hypothetical business with the following on its balance sheet:
- Cash + Cash Equivalents: $20,000
- Marketable Securities: $10,000
- Accounts Receivable: $10,000
- Inventory: $10,000
- Current Liabilities: $$40,000
Quick Ratio is ($20,000 + $10,000 + $10,000) / $40,000 = 1.00
You may have noticed that inventory is excluded from the quick ratio calculation. That’s because inventory typically cannot be reliably liquidated in a short period of time at fair market value – so, it is not a very liquid asset.
A good quick ratio is dependent on your industry and the specifics of your small business. That said, a ratio of one or a little higher is usually good, as you wouldn’t have to rely on inventory to cover current liabilities.
3. Cash Ratio
The cash ratio looks at cash and cash equivalents vs. current liabilities.
Cash Ratio = (Cash + Cash Equivalents) / Current Liabilities
So, a business with $30,000 in cash and cash equivalents and $40,000 in current liabilities would have a cash ratio of 0.75 ($30,000/$40,000).
The cash ratio is a very strict liquidity measurement, making it a useful “stress test” for your small business. In the event of a recession, you might not get paid on time by customers and need cash to satisfy your short-term financial obligations.
And in any economic environment, having a solid cash position reduces your reliance on other, less liquid assets to pay your bills.
The right cash ratio for your small business depends on your business model, industry, and economic outlook. If you expect a recession in the next six months, for example, you may want a cash ratio on the higher side.
4. Gross Profit Margin
Gross profit margin is a profitability measurement that helps business owners compare sales to the costs involved in producing goods.
Gross Profit Margin = (Net Sales – Costs of Goods Sold (COGS)) / Net Sales
Here’s how the gross profit margin would be calculated for a hypothetical business with the following on its income statement:
- Net Sales: $100,000
- Cost of Goods Sold (COGS): $20,000
Gross Profit Margin is ($100,000 – $20,000) / $100,000 = .80 (80%)
This profitability measurement does not include selling, general, and administrative (SG&A) expenses.
While it’s a useful metric for businesses with high COGS, gross profit margin doesn’t provide much insight for businesses with low or no COGS.
A good gross profit margin varies widely, depending on the business model and industry.
5. Operating Profit Margin
Operating profit margin is a profitability measurement that subtracts COGS and operating costs from sales, but doesn’t factor in interest and taxes.
Operating Profit Margin = (Earnings before Interest and Taxes (EBIT)) / Net Sales
EBIT is calculated by taking revenue and subtracting (COGS + SG&A Expenses).
Salaries, accounting expenses, marketing expenses, and rent are examples of SG&A expenses.
Here’s how the operating profit margin would be calculated for a hypothetical business with the following on its income statement:
- Net Sales: $100,000
- Cost of Goods Sold (COGS): $20,000
- SG&A Expenses: $30,000
Operating Profit Margin is ($100,000 – $20,000 – $30,000) / $100,000 = .50 (50%)
Since operating profit margin doesn’t take interest and taxes into account, it’s an excellent way to evaluate the performance of your core business.
A good operating profit margin is heavily dependent on your business model and industry.
RELATED: The Ultimate Guide: How to Calculate Operating Cash Flow
6. Net Profit Margin
Net profit margin is an all-encompassing profitability measurement.
Net Profit Margin = (Net Sales – COGS – All Other Expenses – Interest – Taxes) / Net Sales
Here’s how the net profit margin would be calculated for a hypothetical business with the following on its income statement:
- Net Sales: $100,000
- Cost of Goods Sold (COGS): $20,000
- SG&A Expenses: $30,000
- Interest: $5,000
- Taxes: $15,000
Net Profit Margin is ($100,000 – $20,000 – $30,000 – $5,000 – $15,000) / $100,000 = .30 (30%)
Net profit margin shows what percentage of sales remains after all costs are subtracted.
For businesses with high interest costs, it’s a necessity to not only track gross and operating profit margins, but also net profit margin.
As with gross profit margin and operating profit margin, a good net profit margin varies across business models and industries.
RELATED: What is a Good Profit Margin for Small Businesses?
7. Return on Assets
Return on assets – as the name suggests – allows business owners to see the return they are getting from their assets.
Return on Assets = Net Income / Total Assets
So, a business with $30,000 in net income and $150,000 in total assets would have a return on assets of .20 ($30,000/$150,000).
The usefulness of the return on asset calculation depends on the type of business.
In an asset-intensive business, for example, analyzing return on assets would likely be a worthwhile exercise. In this case, you would want to know how much profit is being generated as a result of large investments in assets.
A good return on assets depends on your business model and industry.
The Bottom Line
Doing financial ratio analysis may seem like a time-consuming endeavor, but there’s a good chance you will get valuable insights for your small business.
For example, maybe you discover your profitability metrics are strong, but your liquidity could be problematic if there’s an economic slowdown. In that case, you can take the right actions to improve your cash position.
In any case, you are likely to find something important that you weren’t previously aware of – at the very least.
And that benefit is worth putting some time aside to do financial ratio analysis.
Gravity Payments provides merchant services and quick and easy funding solutions for small businesses. Contact us to see how we can help your small business.
