The Top 5 Financial Ratios Every Business Owner Needs to Be Using

November 8, 2022
|
Business Basics

You can learn a lot about your company's finances by putting together a statement of cash flows, profit and loss, and balance sheet.

You'll get a full accounting of what you have, what you owe, and where your money is coming from and going. Simple addition and subtraction can only give you so many insights, however.

You can only learn some things by taking the next step in analyzing your business's finances.

Financial ratios are unique metrics you calculate by dividing one line item by another line item—and sometimes multiplied by another factor—to give you a better idea of your company's performance and financial health.

Financial ratios can tell you if your investments have paid off or how efficiently certain lines of business are operating.

The only problem is that there are a ton of financial ratios you can use, and figuring out which ones are useful for your business takes work.

So the question is: What financial ratios should small business owners use?

1. Net Profit Margin

The Net Profit Margin is a measure of your company's profitability. The Net Profit Margin is calculated as follows:

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

For example, let's say a company called BigMoney (or BM for short) finished the year with these numbers:

  • Revenue: $100
  • Expenses: $90

Simple enough, right?

So with those numbers, BM's yearly Net Profit = $100 - $90 = $10, which tells us how much money they made but not what percentage of their earnings was profit. When we plug those numbers into our formula, we see that their Net Profit Margin was 10%.

Net Profit Margin = ($100 - $90) / $100 = 0.1

Knowing the profit margin of one year/accounting period is helpful, but the real value comes when calculating monthly profit margins and plotting them on a graph. That'll give you both an instructive visual and tell you if your profit margins are increasing or decreasing.

2. Current Ratio

Also known as the working capital ratio, this metric measures how well your business can pay its short-term debts based on the number of assets you have. The Current Ratio is calculated like this:

Current Ratio = Current Assets / Current Liabilities

Where Current Assets refer to assets and liabilities expected to be converted to cash within one year, and Current Liabilities refer to short-term debts due within one year or within a normal operating/accounting cycle.

The Current Ratio is a simple measure of the proportion of current debts to assets on your balance sheet. A current ratio of 1 or more means you have more than enough assets to pay off your debts and cover your liabilities.

So if BM has:

  • Current Assets: $110
  • Current Liabilities: $100

Then,

Current Ratio = $110 / $100 = 1.1

By calculating BM's Current Ratio, we see that they have $1.10 in Current Assets for every $1 in short-term debts.

3. Debt Ratio

Assets and Liabilities should always be visible on a balance sheet, but not every liability represents something you'll have to pay off immediately. This ratio shows your company's current debt, putting it in context.

The Debt Ratio is pretty easy to calculate:

Total Debt / Total Assets = Debt Ratio

Ideally, you want this ratio to be as low as possible. A lower number means your company has plenty of assets compared to its debts, while a number above one should set off alarm bells.

For example, let's say BM has the following:

  • Total Assets: $50
  • Total Debts: $100

That means:

Debt Ratio = $100 / $50 = 2

So BM has $2 in debt for every $1 in assets, which is bad news for them and their lenders. Investors would be hesitant to take a chance on a company with so much debt.

4. Return on Assets

This ratio tells you how much money/profit your company makes compared to the amount you have invested in assets.

It's another metric that becomes much more useful when you compare it to previous accounting periods, as it will tell you whether your company has become better or worse at using its assets to generate profits.

Your Return on Assets is calculated using the following formula:

Return on Assets = Net Income / Average Total Assets

You can get the Net Income figure from your Statement of Profit and Loss, while you'll need to calculate the Average Total Assets as:

Average Total Assets = (Current Total Assets – Last Year's Total Assets) / 2

For example, let's say BM has the following:

  • Net Income: $500
  • Average Total Assets: $400

That means:

Average Total Assets = $500 / $400 = 1.25

This means the return on BM's assets is $0.25 per dollar or 25%. That's not too shabby.

5. Inventory Turnover Ratio

This ratio helps analyze the performance of retail businesses. It's valid on its own and as part of a chart or graph tracking the figure over multiple accounting periods. Inventory Turnover is calculated as follows:

Inventory Turnover = Cost of Goods Sold / Average Value of Inventory

Where Cost of Goods Sold is the total amount of costs and expenses associated with producing goods, and the Average Value of Inventory is calculated using the following formula:

Average Value of Inventory = (Current Value of Inventory + Value of Inventory at the end of Prior Period) / 2

For example, let's say BM has the following:

  • Cost of Goods Sold: $100
  • Average Value of Inventory: $10

Therefore:

Inventory Turnover = $100 / $10 = 10

That means BM sold out its entire inventory ten times over the accounting period in question. This implies that BM has strong sales figures.

There are many other financial ratios out there that can give you some good insights into your business. Some are more important or informative than others, and some don't apply to private companies that haven't issued stock, but all of them have their uses.

Just remember that the best way to glean valuable information from these ratios is to calculate them for multiple periods, put them next to each other, and see if you can identify any good or bad patterns emerging.  

AJ Firstman
Written by:
AJ Firstman

Free Download:
The Ultimate Guide to Financial Storytelling

Contact Us
©Amarlo, Inc. 2020 | All rights reserved
Web Design by Team Amarlo