As a small business owner without an accounting background, your eyes may glaze over when you see the term financial ratio. What are financial ratios? Don't fret; financial ratios use your company's financial data to provide information and assess your business's growth, margins and more.
You don’t need an advanced finance degree to use these valuable business tools to know your business better and make more efficient, stronger decisions about how to grow it.
What Are the Most Commonly Used Financial Ratios?
There are dozens of financial ratios that can be used to help gauge your business’s profitability, leverability or inventory management. What are the most important financial ratios in a business?
- Current Ratios
- Debt-to-Equity Ratio
- Profit-Margin Ratio
- Inventory Turnover Ratio
Let's go over each of these common financial ratios and how to calculate them.
1. Current Ratio
A current ratio can be a key in determining your business’s financial health. The idea behind a current ratio is to measure your ability to meet all outstanding obligations, including paying your employees and suppliers and paying off any short-term debt that is due within one year. Sometimes a current ratio is referred to as a working capital ratio.
How to Calculate a Current Ratio
First, you will need a current balance sheet for your business. Locate your most up-to-date asset balance and divide that by your liability balance. You want the current ratio to show that you are able to pay off all of your short-term obligations with your current assets.
Benefits of a Using a Current Ratio
The higher your current ratio, the more financially stable your business is. A current ratio can quickly show how stable your company is, whether your business will run out of money in a year and whether you can pay your bills. It is a quick and efficient way to get a clear picture of some key aspects of your business and to gauge short-term success.
Drawbacks of a Using a Current Ratio
The current ratio does not give a clear picture of your business. Since the current ratio looks at inventory and assets in terms of numbers, it does not look deeper at the quality of inventory or assets. Because the current ratio uses inventory in its calculation, the ratio may be biased.
If there is higher inventory due to low sales or an outdated product, the ratio could show an unbalanced picture of liquidity. In addition, the current ratio will not show how your business compares against other companies.
2. Debt-to-Equity (D/E) Ratio
Debt-to-equity ratios measure how much debt your company has. When you have more debt than average for your type of business, you may be considered a highly leveraged business. A debt-to-equity ratio looks at total debt versus total equity. It compares your total liabilities to your shareholder equity and is used to show how reliant your business is on debt.
The debt-to-equity ratio can tell you and potential lenders how much of your business is financed by debt versus how much is being funded by your own resources. This ratio is often used in corporate finance. It can be added to your annual report.
How to Calculate a Debt-to-Equity Ratio
In most industries, a good debt-to-equity ratio will be about 2 or 2.5. That means that 66 cents of every dollar invested in the company come from debt while 33 cents come from equity. If your debt-to-equity ratio is too low, it may indicate that your business is not taking advantage of debt financing to grow.
Benefits
Debt-to-equity ratios can be used to compare your business with direct competitors. The ratio can help you understand how you are doing in comparison with your competitors and it can thus help you make better decisions about how you run your business, finance your business and how you plan to expand your business.
Drawbacks
A lender or financial institution will want to look at your debt-to-equity ratio before lending you money or investing in your business. A high debt-to-equity ratio may mean that you will not get a loan or you will get a loan with unfavorable terms.
3. Profit Margin Ratio
Profitability margins help you to show your business’s ability to generate income. Profit margin ratios are a common form of profitability ratio that measures your net income earned with each dollar generated by your business. It shows what is left over after you’ve paid all of your expenses.
How to Calculate Profit Margin Ratio
Your profit margin ratio is shown as a percentage. Remember that when calculating your net income, you will need to subtract all of your expenses from your gross income. And when calculating your net revenue, you will need to subtract your returns, discounts and refunds from your gross revenue.
A good profit margin ratio varies by industry. Compare your results against your competitors to get a better picture of what your profit margin ratio says about your business.
Benefits of a Profit Margin Ratio
Your profit margin ratio can be very helpful in making pricing decisions. That’s because it allows a direct comparison between profit and costs at the sales level. Cost savings will give you a higher profit margin. When you use your profit margin accurately, you can fine-tune a pricing strategy to make your business more profitable.
Drawbacks of a Profit Margin Ratio
There can be some disadvantages when using the profit margin. One drawback is that the profit margin ratio is not able to show cost efficiency. Cost efficiency is when you can save money by making a product or process work better. The profit margin ratio is not directly related to cost efficiencies. It is solely related to pricing instead.
One other disadvantage of the profit margin ratio is that it cannot account for your sales volume. If you have a low sales volume, you may still have a high profit margin ratio.
4. Inventory Turnover Ratio
An inventory turnover ratio is a type of asset management ratio. These are ratios that analyze how your business manages its assets to generate sales. An inventory turnover ratio specifically measures your inventory turnover to show how efficiently you manage inventory.
How to Calculate an Inventory Turnover Ratio
Your inventory turnover ratio can be calculated by comparing your cost of goods sold over your average inventory.
Compare your ratio with your competitors. If your inventory turnover ratio is lower than your competitors, then you might be keeping too much inventory on hand or not selling enough.
Benefits of an Inventory Turnover Ratio
One of the key benefits of an inventory turnover ratio is that it can show a clear picture of how efficiently your business is managing its inventory. Many business owners search and search for that perfect balance between storing too much inventory and too little. This particular ratio is key to helping your business strike that balance. When you can minimize your inventory without impacting your sale, you can perform more efficiently.
Drawbacks of an Inventory Turnover Ratio
The inventory turnover ratio comes with a few drawbacks. If the total inventory is looked at without taking into account specific items, then you will not be able to really fine-tune your inventory management. It is important to balance an average inventory turnover ratio with a more fine-tuned look at specific inventory items to focus on the slow-moving items and tweak their levels.
In addition, a high ratio is not always a good thing on its own. A high inventory turnover ratio could be an indicator that you are not fulfilling your orders quickly enough. It is important to have a full host of inventory management tools available in addition to the inventory turnover ratio.
When you have a number of financial ratios at your fingertips, you are better able to analyze your company’s financial standings and make better decisions to grow your business. Incfile’s Accounting and Bookkeeping services can help make your job easier. For a small monthly fee, we take care of all your accounting and tax needs without you having to search for the right accountant or bookkeeper elsewhere.
Nicole Bowman
Nicole Bowman is a freelance writer who thinks turning research into stories is the best gig ever. She started writing billboards back in 2002, worked in book publishing in New York for many years and now she creates all sorts of engaging content for the web. Nicole lives in Rehoboth Beach, DE, with her husband, two sons and their poodle, Tootsie. She loves the great outdoors, bookstores and tennis.
