If you’re a small business owner, then you know that financial stability is key to your success. You also know that it can be difficult to maintain financial stability when you’re just starting out. That’s why it’s important to track your financial ratios and make sure they are in good shape.

This article will discuss the most important financial ratios for small businesses and explain how to calculate them. We’ll also provide some tips on how to improve your ratios and stay financially healthy.

What is a Financial Ratio?

A financial ratio is a mathematical comparison of two financial variables. Ratios can be used to compare companies, industries, or even different time periods. Financial ratios are usually expressed as a percentage or decimal value.

There are four main categories of financial ratios:

• Liquidity
• Leverage
• Profitability
• Asset management

Let’s take a closer look at each category.

• Liquidity Ratios: Liquidity ratios measure a company’s ability to pay its short-term debts. The most common liquidity ratio is the Current Ratio, which measures the number of current assets (such as cash and accounts receivable) relative to current liabilities (such as accounts payable and short-term debt).
• Leverage Ratios: Leverage ratios measure a company’s use of debt financing. The most common leverage ratio is Debt to Equity, which measures the amount of debt relative to equity.
• Profitability Ratios: Profitability ratios measure a company’s ability to generate profits. The most common profitability ratio is the Net Profit Margin, which measures the percentage of revenue that is left after all expenses are paid.
• Asset Management Ratios: Asset management ratios measure a company’s efficiency in using its assets. The most common asset management ratio is Inventory Turnover, which measures the number of times inventory is sold and replaced over a period of time.

Why are Financial Ratios Important?

Financial ratios are important because they provide insights into a company’s financial health. Ratios can be used to identify trends, compare companies, and make decisions about investing.

For example, let’s say you’re considering investing in Company A and Company B. Both companies are in the same industry and have similar sales figures.

However, when you look at their financial ratios, you notice that Company A has a much higher debt-to-equity ratio than Company B. This could be a sign that Company A is riskier and less stable than Company B. As an investor, you would likely choose to invest in Company B over Company A.

Similarly, if you’re a small business owner, tracking your financial ratios can help you identify problems early on and make changes to improve your financial health.

For example, let’s say your current ratio is low. This could be a sign that you’re using too much debt or that your expenses are too high. By tracking this ratio, you can take steps to reduce your debt and improve your financial stability.

Top 6 Financial Ratios to Measure

There are hundreds of financial ratios to keep track of, but only six are extremely important. These are:

1. Current Ratio

This ratio measures a company’s ability to pay its short-term debts with its current assets.

To calculate the current ratio, divide your current assets by your current liabilities.

Current Ratio = Current Assets/Current Liabilities

For example, let’s say your company has $100,000 in cash and $50,000 in accounts receivable. You also have $40,000 in accounts payable and $30,000 in short-term debt.

Your current ratio would be:

$100,000/$50,000 = two times or 200%

This means that you have enough assets to cover your liabilities two times over. A healthy current ratio is between one and two times.

If your current ratio is less than one, it means you have more liabilities than assets and may have trouble paying your debts.

If your current ratio is greater than two, it means you have more assets than liabilities and may be able to use your excess cash to pay down debt or invest in growth opportunities.

2. Quick Ratio

This ratio is similar to the current ratio, but it only includes assets that can be quickly converted to cash.

To calculate the quick ratio, divide your quick assets by your current liabilities.

Quick Ratio = Quick Assets/Current Liabilities

For example, let’s say your company has $100,000 in cash and $50,000 in accounts receivable. You also have $40,000 in accounts payable and $30,000 in short-term debt.

Your quick ratio would be:

$100,000/$40,000 = two and a half times or 250%

This means that you have enough liquid assets to cover your liabilities two and a half times over. A healthy quick ratio is between one and two times.

3. Days of Working Capital

This ratio measures how long a company can continue to operate if it doesn’t generate any new revenue. To calculate days of working capital, divide your current assets by your daily operating expenses.

Days of Working Capital = Current Assets/Daily Operating Expenses

For example, let’s say your company has $100,000 in cash and $50,000 in accounts receivable. You also have $40,000 in accounts payable and $30,000 in short-term debt. Your daily operating expenses are $20,000.

Your days of working capital would be:

$100,000/$20,000 = five days

This means that you could continue to operate your business for five days without generating any new revenue.

Ideally, you want your business to have enough cash on hand to cover at least three months of operating expenses. This gives you a cushion in case of an emergency or a slow period.

If your days of working capital are less than one, it means you don’t have enough cash on hand to cover even one day of operating expenses and may need to take out a loan or line of credit to keep your business afloat.

4. Debt to Equity Ratio

This ratio measures the amount of debt a company is using to finance its growth. To calculate the debt-to-equity ratio, divide your total liabilities by your shareholder equity.

Debt to Equity Ratio = Total Liabilities/Shareholder Equity

For example, let’s say your company has $100,000 in total liabilities and $50,000 in shareholder equity.

Your debt-to-equity ratio would be:

$100,000/$50,000 = two times or 200%

This means that you’re using debt to finance half of your company’s growth. A healthy debt-to-equity ratio is between one and two times.

5. Profit Margin

This ratio measures how much profit a company is making relative to its revenue. To calculate the profit margin, divide your net income by your total revenue.

Profit Margin = Net Income/Total Revenue

For example, let’s say your company has $100,000 in net income and $200,000 in total revenue.

Your profit margin would be:

$100,000/$200,000 = 50%

This means that you’re making 50 cents of profit for every dollar of revenue. A healthy profit margin is between five and ten percent.

If your profit margin is less than five percent, it means you’re not making enough money to cover your expenses and may need to raise prices or cut costs.

6. Inventory Turnover Ratio

This ratio measures how quickly a company is selling its inventory. To calculate the inventory turnover ratio, divide your cost of goods sold by your average inventory.

Inventory Turnover Ratio = Cost of Goods Sold/Average Inventory

For example, let’s say your company has $100,000 in cost of goods sold and $20,000 in average inventory.

Your inventory turnover ratio would be:

$100,000/$20,000 = five times

This means that you’re selling your inventory five times as fast as you’re buying it. A healthy inventory turnover ratio is between two and four times.

Final Thoughts

As you can see, there are a variety of financial ratios that you can use to measure the health of your small business. While no single ratio is perfect, they can give you valuable insights into how well your business is performing and where improvements may be needed.

Learning all these and applying them on your own can be difficult and may not be worth your time. Hire a reputable accountant instead so you can focus on running your business. One of the most trusted accounting firms in Miami that you can turn to is Swiftbooks, LCC. Call 786-204-2881 to book a consultation today.