Your car has gauges that tell you how it's performing. There's a gauge to tell you how fast you're going, one that gives you the temperature of your coolant and another that reports the oil pressure in the engine.
Your business has gauges that tell you about its performance, too. They’re called financial ratios. The data used to calculate these financial ratios is readily available on your company’s financial statements.
Here are the main types of financial ratios you can use to check the performance of your business and compare your business to industry averages.
Read More: Importance of Financial Ratios
The first thing you want to know is whether you're making a profit and how much. These ratios are percentages that give you the profit performance of your business at different points on your income statement.
Gross profit margin: The first profit indicator on your income statement is the gross profit margin. You can find this indicator by subtracting the cost of goods sold – which includes labor, materials and supplies – from total sales. Then, divide that number by total sales and multiply by 100. If a business had total sales of $1,000,000, cost of goods sold of $600,000, its gross profit margin would be 40 percent ($1,000,000 minus $600,000 divided by $1,000,000).
The gross profit margin tells you how efficiently you are using your costs of labor and materials to produce products and services. It must be high enough to cover your fixed overhead expenses and leave a reasonable net profit.
Earnings before interest, taxes, depreciation and amortization (EBITDA): EBITDA measures the profit of your business before deductions for interest costs and accounting entries, such as depreciation and amortization.
Net profit margin: The net profit margin is the profit left after deducting all operating expenses divided by total sales. If your business had sales of $1,500,000 and $90,000 in net profits, its net margin would be 6 percent ($90,000 divided by $1,500,000).
You can compare this figure to the industry averages for your competitors. If your company is earning 6 percent while the industry average is 10 percent, you need to find out why your business is earning less.
Read More: What Do Financial Ratios Tell You?
The next group of financial ratios measures the liquidity of your operations. These ratios tell you if you have enough money in the bank to meet payroll, cover operating expenses and pay your suppliers.
Current ratio: You can find your current ratio by dividing total current assets by total current liabilities. The general rule of thumb is to have $2 in current assets – which includes inventory, accounts receivable and cash – for each $1 in short-term current liabilities, in other words, a 2 to 1 ratio.
Quick ratio: A stricter test of a company’s liquidity is the quick ratio, also known as the acid test ratio. This ratio considers only a company's cash position plus accounts receivable divided by total current liabilities. If a company has $50,000 in cash, $100,000 in accounts receivable and $100,000 in current liabilities, its quick ratio would be 1.5 to 1 ($50,000 plus $100,000 divided by $100,000). A quick ratio less than 1 to 1 would mean the company doesn’t have enough liquidity to meet its short-term liabilities on time.
Working capital: Working capital is a different way of looking at your liquidity. You can calculate your working capital by subtracting current liabilities from current assets. For example, if you have $300,000 in current assets and $150,000 in current liabilities, your working capital is $150,000 ($300,000 minus $150,000).
If your business is making a profit, working capital should always be increasing. If it goes down, there's a problem somewhere in your operations and you need to find out why.
Efficiency ratios show you how effectively you are using your assets to get a return on your investment.
Inventory turnover: For most businesses, inventory represents a sizable investment and use of funds. The goal is to maintain a low inventory and turn it over into sales as quickly as possible.
You can calculate your annual inventory turnover by dividing the year's cost of goods sold by the average inventory level. For example, if you had $800,000 in cost of goods sold last year and your average inventory level was $200,000, your inventory turnover would be four times ($800,000 divided by $200,000). or approximately every 90 days. Whether this is good or not depends on the norm for your industry.
Accounts receivable turnover: After you’ve sold your inventory, you want to turn your accounts receivables into cash as quickly as possible. If you're giving your customers 30-day terms, then your receivables turnover should be 12 times per year if all your customers paid on time. However, if your accounts receivable turnover starts creeping up to 45, 50 or 60 days, there’s a problem with your collection procedures that needs attention.
Read More: Why Are Income Statements Important?
Leverage ratios show how much debt you have in relation to your equity. Generally, companies with higher amounts of debt compared to equity are riskier. They face more severe consequences in an economic downturn than companies with more equity than debt.
Debt-to-equity ratio: The debt-to-equity ratio is a metric that reveals the financial leverage of a business. The calculation is simple: Divide total debt liabilities by equity. If a business has $300,000 in debt and $150,000 in equity, the debt-to-equity ratio is 2 to 1. Generally, a safer ratio is to have $1 in debt for each $1 in equity.
Interest coverage: This ratio measures the company's ability to pay the interest on its debt. It’s found by dividing the business’s earnings before deductions for interest and taxes (EBIT) by the interest expense for the same time period. If a company has EBIT of $150,000 and $50,000 in interest costs, its interest coverage ratio is 3 to 1, which is considered adequate coverage. When the interest coverage ratio drops below this level, companies will begin to experience difficulty in meeting their debt payments.
How to Use Financial Ratios
You can judge the financial health of your business by comparing your company’s financial ratios with industry averages for profitability, liquidity, efficiency and leverage. Some of this financial information is available online, but you may have to go to your industry’s trade association to get more detailed data.
Small business owners and entrepreneurs compare the performance of their businesses to predetermined benchmarks. Deviations from these standards require attention and steps to take corrective actions. You can track the trend of changes in these ratios to find out if you're making any progress at improvement.
You can also use these groups of financial ratios in a business plan for a startup to establish performance benchmarks for financial analysis as the business grows and develops.
- Business Development Bank of Canada: How to Use Financial Ratios to Improve Your Business
- Zions Bank: How to Analyze Your Business Using Financial Ratios
- Inc.com: 3 Financial Ratios That All Successful Small Business Owners Need to Track
- Entrepreneur: Financial Ratios Are How You Know If What You're Doing Is Working
- Business Development Bank of Canada: 4 Ways to Assess Your Business pPerformance Using Financial Ratios
James Woodruff has been a management consultant to more than 1,000 small businesses. As a senior management consultant and owner, he used his technical expertise to conduct an analysis of a company's operational, financial and business management issues. James has been writing business and finance related topics for work.chron, bizfluent.com, smallbusiness.chron.com and e-commerce websites since 2007. He graduated from Georgia Tech with a Bachelor of Mechanical Engineering and received an MBA from Columbia University.