Keeping accurate records and tracking your business’s financial progress gives you a good idea of where your business stands – but financial ratios add an even deeper understanding of your business. With these ratios, you can move forward with greater confidence that you’re making the right decisions to maintain and grow your business.
In this overview, you’ll learn the best financial ratios for small business, what they are and the insight they give, as well as how to calculate them.
Why do financial ratios matter?
Financial ratios are simple calculations drawn from your business’s financial statements. You use the information from your balance sheet, income statement, and cash flow statement to spot strengths and areas for improvement that can be more targeted than your overall business reports.
Think of it this way: To stay on course and reach a desired destination – in this case, building a successful business – you need reliable tools to monitor your progress and make informed decisions. Financial ratios are a key tool – like a GPS for your business – to support your goals.
How do financial ratios help your business grow?
There are several ways financial ratios can encourage your business to grow:
- You can monitor your business’s financial health more accurately. Similar to the ways that GPS can help you see your current location in relation to your starting and end points, financial ratios give you snapshots of your business’s financial condition at specific points in time.
- They help you make more informed decisions. Just as GPS and road signs guide you to your destination, financial ratios can guide your business decisions.
- They give you a closer look at performance benchmarks. Financial ratios give you the ability to benchmark your business’s performance against industry standards or competitors, like how you benchmark your progress on a trip to estimated arrival times.
- They enhance communications with your stakeholders. Financial ratios provide a clear, common language to communicate your business’s financial health to investors, lenders, and other stakeholders. This transparency builds trust and confidence.
- They identify opportunities and potential problems. Road signs warn you of upcoming conditions to give you a chance to prepare and adjust your driving. Similarly, regularly reviewing financial ratios lets you identify trends and patterns to leverage opportunities or implement corrective actions.
Understanding financial ratios: The basics
The information you gain from financial ratios can give you a better understanding of your business’s performance and financial health.
The common categories of financial ratios include:
- Profitability ratios: These include net-profit margin and return on assets, which measure your business’s ability to consistently generate profit. For example, if your net profit margin is lower than the industry average, you might need to consider strategies to cut costs or boost revenue. The ratio for return on assets shows how efficiently your business uses resources to generate profits. With this, you can make adjustments to stay on the right path.
- Liquidity ratios: These include the current and quick ratio calculations to assess your business’s ability to meet short-term financial obligations. Think of these like a measure of gas in your tank, versus the distance you’re traveling. These ratios help you understand if you’ve got enough liquidity to keep on track to your goals.
- Leverage ratios: An example is the debt-to-equity ratio. This evaluates the extent of your business’s financing (debt) to your available equity. These can determine whether it’s a good idea to reduce debt.
- Efficiency ratios: These include inventory turnover and accounts-receivable turnover, which show how effectively your business is managing its assets. For example, if your inventory-turnover ratio is low, it signals that you may need to adjust your inventory levels, get rid of some products or services, or improve your sales strategy.
The Top 10 best financial ratios for small business
Here’s a list of essential financial ratios for your small business health. Try calculating each of these for your business to see if you can learn something new or gain a fresh perspective on an existing opportunity or challenge.
Profitability ratios
1. Net profit margin: This determines the percentage of revenue that you have as profit after all expenses are subtracted. It reveals the overall profitability of your business, as well as your effectiveness at managing expenses. Although it varies by industry, a net profit margin of 20% is considered very good, 10% is average, and 5% is a red flag.
Net profit margin = (Net Income/Total Revenue) × 100
Example: Net income = $20,000
Total revenue = $120,000
Net profit margin = ($20,000/$120,000) x 100 = about 16%
2. Gross profit margin: This measures the percentage of revenue that exceeds the cost of goods sold (COGS). This ratio shows the overall efficiency of your production and pricing strategies. As with many financial ratios, a healthy gross profit margin determination will depend on your industry. For example, in retail a 50% gross profit margin demonstrates a healthy business, while in the finance industry, this would be considered poor and should be closer to 80%.
Gross profit margin = ((Revenue – cost of goods sold)/revenue) × 100
Example: Total revenue = $120,000
COGS = $40,000
Gross profit margin = (($120,000-$40,000)/$120,000) x 100 = 66%
3. Operating profit margin: This identifies the percentage of revenue left after covering your operating expenses. It shows the efficiency of your core business operations.
Operating profit margin = ((Total revenue – operating expenses)/revenue)) × 100
Example: Total revenue = $500,000
Operating expenses = $200,000
Operating profit margin = (($500,000-$200,000)/$500,000)) x 100 = 60%
Liquidity ratios
4. Current ratio: This measures your business’s ability to cover short-term liabilities with short-term assets. A current ratio of 1:1 or higher means that your business has enough liquid assets to cover current liabilities. On the other hand, a ratio of less than 1.0 signals that your business will likely come up short if no action is taken.
Current ratio = Current assets/current liabilities
Example: Current assets = $300,000
Current liabilities = $250,000
Current ratio = $300,000/$250,000 = 1.2
5. Quick ratio (aka, “acid-test” ratio): This shows your business’s ability to meet short-term obligations with its most liquid assets. It’s a more stringent – and, in many cases, more realistic – financial snapshot of your business’s liquidity. As with the current ratio, a ratio of 1:1 means your business is relatively healthy, while a ratio below that suggests that your liquidity may fall short.
Quick ratio = (Current assets – inventory)/current liabilities
Example: Current assets = $300,000
Current inventory = $60,000
Current liabilities = $250,000
Quick ratio = ($300,000 – $60,000)/$250,000 = .96
Leverage ratios
6. Debt-to-equity ratio (D/E): This ratio determines the proportion of your business’s financing that comes from debt versus equity. It can help you and potential investors or lenders understand your business’s financial leverage and debt risk. While a D/E ratio above 2.0 is generally considered higher risk, it’s common for businesses in the early stages of startup or while in expansion mode.
Debt-to-equity ratio = Total liabilities/shareholders’ equity
Example: Total liabilities = $200,000
Shareholders’ equity = $100,000
D/E ratio = $200,000/$100,000 = 2
7. Debt service coverage ratio (DSCR): This is used to spot whether your business’s earnings before interest, taxes, depreciation, and amortization (EBITDA) can cover annual principal and interest payments. It shows the current level of your financial leverage and risk, which is why it’s commonly used by lenders and investors. Although this varies by lender and circumstance, a DSCR above 1.25 is typically considered the minimum for a loan. The following example is a very simplified version of this more complex ratio.
Debt service coverage ratio (DSCR) = EBITDA/Annual principal and interest payments
Example: EBITDA = $100,000
Annual principal and interest payments = $40,000
DSCR = $100,000/$40,000 = 2.5
8. Debt/net worth ratio: This measures the level of debt relative to your business’s net worth. It demonstrates how capable your business is to pay its debts if problems arise. A debt to net worth ratio of less than 1.0 is considered stable and healthy, as it shows that your business’s net worth exceeds its level of debt. As with most ratios, this one needs to be considered in the context of your business’s current phase and goals (startup/early stages, expansion, etc.).
Debt/net worth ratio = Total debt/net worth
Example: Total debt = $410,000
Net worth = $400,000
Debt/net worth ratio = $410,000/$400,000 = 1.025
Efficiency ratios
9. Inventory turnover: This identifies how often inventory is sold and replaced over a period of time. It explains how efficiently your business manages inventory and can guide you to make better decisions regarding pricing, purchasing/ordering, marketing, and more. You can typically calculate this over a given period, such as a week, month, or quarter, then use that figure to calculate an average inventory ratio over your fiscal year. Once again, context is key in interpreting this ratio as it varies greatly by industry.
Inventory turnover ratio = COGS/Average value of inventory
Example: COGS = $100,000
Average value of inventory = $170,000
Inventory turnover ratio = $100,000/$70,000 = about .59
10. Accounts receivable turnover: This demonstrates how effectively your business collects on your receivables. Simply put, it shows whether those who owe you money are paying you. This allows you to forecast and strategize cash flow more effectively, and determine whether your business credit-extending policies need review and reconsideration.
Accounts receivable turnover = Net credit sales/average accounts receivable
Example: Net credit sales = $100,000
Average accounts receivable = $20,000
Accounts Receivable Turnover = 5.0
Pursuit can help you improve financial management and more
The best financial ratios for small business can help you strengthen your financial foundation and boost profitability – and Pursuit’s loans and line of credit can help you achieve your goals. We’re a leading small business lender throughout New York, New Jersey, Pennsylvania, Connecticut, Illinois, and Nevada, and every day, we help entrepreneurs get financing to launch and grow.
Contact us to learn more.
