Financial Ratios for Business -Simply said financial ratios are tools that may help you turn your raw data into information that will help you manage your organization more efficiently. Gross sales and net profits are two measures that many small business owners constantly review, but they can only provide so much information.
Simply said, financial ratios are tools that may help you turn your raw data into information that will help you manage your organization more efficiently. Gross sales and net profits are two measures that many small business owners constantly review, but they can only provide so much information.
Financial Ratios for Businesses to Track
There are several ratios that you may track, but to avoid being overwhelmed, you should focus on a small number of ratios. These are the ratios you should include in your shortlist:
Cash Flow to Debt
(Net Income + Depreciation) ÷ Total Debt = Cash Flow to Debt Ratio
Month after month, businesses make money, yet they still have cash flow problems. Why? They largely rely on paying off debt to maintain their cash flow. Since a lack of cash flow is a major factor in small business failure, the cash flow to debt ratio may be an important warning flag at this point.
When debt is approaching its maturity date, it frequently doesn’t create a liquidity problem. Perhaps you took out a loan from a friend or relative to start your business. If you are not making payments, it is easy to forget what the next due date is. You are suddenly obligated to pay back the debt but lack the accessible finances to do so.
Monitor cash flow utilising the cash flow to debt ratio so that you don’t run the danger of alienating individuals who kindly helped you start your firm.
Net Profit Margin
(Total Revenue – Total Expenses) ÷ Total Revenue = Net Profit Margin
The percentage of revenue left over after deducting all operational costs, interest, and taxes is known as the net profit margin. Because it shows a company’s proficiency in managing expenditures and turning revenues into profits, the net profit margin is a popular topic among investors.
The net profit margin indicates the amount of profit leftover from each dollar of sales. Thus, a 10% profit margin indicates that the corporation retains 10% of every dollar sold as profit.
Gross Margin Ratio
(Sales – Cost of Goods Sold) ÷ Total Sales = Gross Margin Ratio
This is a crucial ratio to keep an eye on if your business sells products. How much cash do you have after paying for the goods you sold to meet operating costs? (such as marketing, employees, and rent).
This ratio may be calculated for individual products or for your entire organisation. For instance, if you are a retailer of clothes, you may determine gross margin by-products, such as jeans, or by category of apparel.
The greater your gross margin, the more money you have leftover to cover other business expenditures. A low gross margin indicates that you may have difficulty covering operational expenditures.
(Cash + Marketable Securities + Net Accounts Receivable) ÷ Current Liabilities = Quick Ratio
Any organisation with current liabilities, such as accounts payable, short-term loans, payroll taxes, income taxes, credit card debt, and other incurred expenses, benefits from the quick ratio, often known as the acid test.
This ratio indicates your liquidity by indicating if your current assets (cash, liquid investments, and accounts receivable) are sufficient to meet your current liabilities. Can you maintain the viability of your firm in the face of a temporary setback?
A fast ratio of 2.0 indicates that you have enough liquid assets to meet each dollar of current liabilities. The greater your quick ratio, the more advantageous your position.
Accounts Receivable Turnover
(Total A/R Outstanding ÷ Total Sales) x Number of days = A/R Turnover
Also referred to as days sales outstanding (DSO), accounts receivable (A/R) turnover indicates how well your business collects payments. That is, the time it takes for a business to receive paid once a transaction is made.
Many businesses struggle with cash flow, and being paid fast may be the difference between a firm struggling to pay invoices and one that is quite confident in its financial situation.
If your A/R turnover begins to increase, it is an indication that you should devote additional attention to improving your receivables process.
Inventory Turnover Ratio
Cost of Goods Sold ÷ Average Inventory = Inventory Turnover Ratio
The inventory turnover ratio, as the name indicates, is beneficial for organisations that maintain inventory. It indicates how frequently inventory was converted to sales during a certain time period. You may compute it monthly, quarterly, or annually.
A high inventory turnover ratio suggests that you are often replenishing your inventory. Businesses that deal in perishable goods, such as food, will have a greater inventory turnover ratio than those that deal in more expensive, non-perishable goods.
You may determine whether you are spending money on storage or hoarding cash in slow-moving or unsellable products by calculating your inventory turnover ratio. Given that inventory is typically one of the largest assets included on a retailer’s balance sheet, investors frequently use this to determine the liquidity of a company’s inventory. If the inventory cannot be sold, it has little worth to the company.
Creditors commonly employ this ratio as well, as inventory is regularly used as collateral for loans. Banks want to know that your merchandise will be easy to sell before they provide money.
If you are considering more finance for your firm, whether from an outside investor or a small business loan, review your inventory turnover ratio and make necessary adjustments.
Sales Per Employee
Annual revenue ÷ Number of employees = Sales per Employee
Sales-per-employee can be an accurate estimate for organisations that require a high number of people, such as service-based firms.
If your company has a high sales-per-employee ratio, it means that resource allocation inside the company is very effective (people). Without an unduly big workforce, you can do a lot of work.
Use Financial Ratios
Financial ratios offer a glimpse of your company at a certain period. This is helpful, but analysing trends can help you get the most out of your financial ratios. Track and compare the ratios throughout time as opposed to calculating them once and attempting to determine if the results are good or bad.
The simplest way to accomplish this is to use a spreadsheet to monitor the ratios you compute over time. Take the required information out of your accounting system each quarter, then compute the ratios.