Financial ratios can be powerful tools in determining how your business is performing is and where it’s going.
“Ratios are the Cliff Notes of finance,” says consultant Marilyn Landis of Pittsburgh-based Basic Business Concepts. “They give you a quick overview to spot problems and opportunities, so you can dig deeper to find root causes and solutions.” Landis and other experts suggest focusing on a few key ratios—some universal, others specific to your industry or company—to keep your finger on the pulse of your business. “Ratios should be checked on a regular basis, because trends—whether they’re going up, down, or staying the same—tells you more than an individual measurement,” she adds.
The key financial ratios pertinent to just about any business fall into four broad categories: liquidity ratios measure your ability to meet current and upcoming obligations; asset ratios measure your company’s financial efficiency; debt ratios highlight vulnerability to risk, and profit ratios gauge profitability against a number of measures.
Here’s a look at key financial ratios in each category, how to calculate them, and what they tell you about your business:
- Liquidity: Current Ratio (current assets / current liabilities). “Businesses should check this at least once a month,” Landis says. “What the current ratio tells you is how much you have in cash, or will turn into cash, in the next 12 months for every dollar that you have coming due in the same period.” Typically, a current ratio of 1 or 1.2 is considered healthy. “Obviously if it drops below 1, you have a problem: Not enough liquidity to meet your upcoming payables. But if it inches up higher, maybe you’re not investing your excess cash correctly, or your inventory is creeping up on you.” Components of the current ratio worth examining include days in accounts receivable (how long on average it takes you to get paid, calculated as: average A/R / sales x 360) and days in inventory (average inventory / cost of goods sold x 360), which are technically measures of efficiency (see “Efficiency,” below). Landis finds another common ratio, the quick ratio or acid-test ratio (cash + accounts receivable / current liabilities), which excludes inventory, less helpful for business owners, though lenders often use it to assess applicants.
- Efficiency: return on assets (net income / total assets). This figure indicates how efficiently you’re converting your investment in real estate, equipment and other assets into revenue. Take two competitors in the same industry, making the same return of $1 million each. But Company A did so on assets of $4 million, for a 25 percent ROA, while Company B poured in $5 million, for an ROA of 20 percent. Here, too, the numbers may not tell the whole story. What if, for instance, the additional $1 million that Company B paid out was a strategic investment in new technology or markets that would give it a significant competitive advantage in the near future? Other measures of efficiency indicate how quickly you move through the cash flow cycle. These include accounts receivable turnover (net sales / average A/R), inventory turnover (COGS / average inventory), and accounts payable turnover (COGS / average A/P). The higher the numbers, the more quickly you are receiving cash for your outlays.
- Risk: debt to equity(total liabilities / shareholder equity). Lenders often look at this financial ratio to determine how well capitalized your company is, but Landis puts it somewhat differently: “The higher the ratio, the more dependent you are on future profits to pay for your debt,” she explains. In other words, the more you’re betting on the future. A smaller number means you are funding your operation off of profits already in the bank. Again, the number means little without context. While lower is generally better, it may be high if, for instance, you’ve just drawn from a line of credit to purchase inventory for a contract project yet to generate receivables. Another useful ratio to evaluate debt-related risk is the debt coverage ratio (net profit + non-cash expenses such as depreciation / total liabilities), which indicates how much of your cash profits are available to repay your debt.
- Profitability . There’s profit, of course, and then there’s profit. Gross profit (gross sales / cost of goods sold) may tell you what you make off of each sale, but net profit (gross sales / total expenses) is what you literally take to the bank. The difference is overhead, which can also be expressed as a ratio, SG&A to sales (selling, general & administrative expenses) / gross sales, something you want to keep steady or lower over time.
Finding yourself bogged down in a sea of numbers? A concise dashboard of critical financial ratios can help you cut through the clutter.
This information is general in nature, is provided for educational purposes only, and should not be relied on or interpreted as accounting, financial planning, investment, legal or tax advice. Regions neither endorses nor guarantees this information, and encourages you to consult a professional for advice applicable to your specific situation.