A thorough understanding of your small business’s financial health means learning to read between the lines of the financial statements and using critical calculations to examine your position.
Two common ratios are the quick ratio and gross profit margin ratio. Many successful business owners regularly use these to evaluate performance and identify potential financial, sales, or production issues.
Financial ratio #1: Small business quick ratio
The quick ratio (also known as liquidity ratio) is one of the most important because it gives you a quick look at your cash position, including the ability to make upcoming debt payments and purchases, on a short-term basis (this can be daily, weekly, monthly, or quarterly, depending on your business).
A higher ratio signifies a better position, with a ratio of 2.0 or more usually indicating that the business is primed for additional growth. A ratio of less than 1.0, however, typically means that the business doesn’t have sufficient liquid (immediately available) resources to cover current debt, putting it at substantial risk.
Calculating quick ratio:
To calculate quick ratio, add up your business’s available cash, cash equivalents (like inventory that turns over quickly), short-term investments (if any), and accounts receivable. Then, divide this total by your business’s current liabilities, like outstanding loans, bills and costs for inventory or services.
(Cash and Cash Equivalents + Short Term Investments + Accounts Receivable) ÷ Current Liabilities
Here are two examples, Bakery A and Bakery B, that show very different pictures of a business’s financial health:
Bakery A: $1,000 + Cash on-hand (business checking)
$2,000 + Cash equivalent (ingredients/inventory for the month)
$1,000 + Accounts receivable
/$5,000 (Rent/utilities, advertising, payroll)
= .8
Bakery B: $7,000 + Cash on-hand (business checking)
$2,000 + Cash equivalent (ingredients/inventory for the month)
$1,000 + Accounts receivable
/$5,000 (Rent/utilities, advertising, payroll)
= 2.0
Bakery A’s monthly expenses exceed available cash and the financial health of the business is at risk. Bakery B, however, has more available cash, so it’s better positioned for stability and growth. (If, like Bakery A, your business needs working capital, a Pursuit SmartLoan can help.)
Financial ratio #2: Small business profitability ratio using gross profit and gross profit margin
This second set of calculations is used together to show how profitable your business is in relation to the cost of producing and delivering your goods or services.
Gross profit is simply your sales less the cost of goods or services sold. For example, if you sell $10 in widgets that cost you five dollars to produce, your gross profit is five dollars.
You then use this number to calculate your gross profit margin ratio, which measures how much money you make from selling your products or services expressed as a percentage. This ratio essentially measures the profitability of your business above the cost of goods or services sold, and shows whether you have money left over for current expenses, savings or investment into the business. A healthy gross profit margin enables you to absorb fluctuations to revenues or costs of goods without losing the ability to pay for ongoing expenses.
The closer the gross profit margin ratio is to one (or 100%), the higher the profitability of the business. On the other hand, the closer the ratio is to zero, the more it indicates that most of the income from sales is eaten up by producing your goods or services. Knowing this can help you make smarter decisions about production, delivery, packaging, or any other factors that impact your business’s profitability.
Calculating Gross Profit and Gross Profit Margin:
Gross Profit = Sales – Cost of Goods Sold
Gross Profit Margin = Gross Profit ÷ Sales
Using the previous widget example, the gross profit on the widgets is five dollars. The gross profit margin, then, is five dollars divided by ten dollars, or .5, or 50%, which indicates that the business is stable in the short-term, but has room for improvement. If, however, the gross profit on the widgets was three dollars (meaning that it cost seven dollars to produce $10 in sales), that would be three dollars divided by ten dollars (gross profit divided by sales), with a gross profit margin of .3 (or 30%) – indicating a critical need for improvement.
And what if your calculations indicate that it only costs you two dollars to produce $10 in widget sales, giving you a gross profit of eight dollars and a ratio of 80%? This shows you’re on track to a stronger and more successful business.
