Using Financial Ratios for Your Small Business
by Margot Carmichael Lester, Staples® Contributing Writer
Most of us only think of ratios when wagering odds (that horse is going out at 10:1) or cooking (2 parts vinegar to 1 part oil). But understanding and tracking key financial ratios is a business owners best bet, and a key ingredient in the recipe for success.
Get to know common ratios that are important for running your small business:
Financial Ratio #1: Acid-Test, Liquid or Quick Ratio
What Is It? This is one of the important liquidity ratios. Liquidity refers to how fast you can convert something to cash, explains Lisa Drake, a CPA specializing in small business and an accounting professor at Foothill College in Los Altos, CA.
What Does It Mean? Cash is king and you want to make sure you know exactly how liquid you are and that your debt is manageable, Drake says. This liquidity ratio gives you a quick look at your cash position and ability to make upcoming payments and purchases.
How to Calculate Quick Ratio:
(Cash and Cash Equivalents + Short-Term Investments + Accounts Receivable) ÷ Current Liabilities
Cash equivalents and short-term investments are basically financial assets owned by the company that can be easily sold, like stock and certificates of deposit. Current liabilities are payments due in the next 12 months, like accounts payable, credit cards, etc.
Financial Ratio #2: Gross Profit & Gross Profit Margin
What Is It? The gross profit margin ratio measures how much money you make from selling your products or services expressed as a percentage.
What Does It Mean? This ratio shows how profitable you are above the cost of goods sold, and whether you have money left over for current expenses, future expenses, savings and/or investing. You can use this ratio to forecast short-term impacts on your business from selling more or less than you expected, says Rendell Richards, CFO and partner at Scale Finance in Greensboro, NC. The company, which has offices in North Carolina, Florida, Tennessee and Washington, DC, provides contract CFO services, controller solutions and other financial services.
How to Calculate Gross Profit Margin:
Gross Profit ÷ Sales
To do this equation, you can first calculate:
Gross Profit = Sales - Cost of Goods Sold
Sales are $200. So if your cost of goods sold is $80, your gross profit is $120, and your gross profit margin is 60% of sales.
Financial Ratio #3: Operating Profit Margin
What Is It? This is the profit earned from normal business operations, excluding investments, interest and taxes. It is also known as earnings before interest and tax (EBIT), expressed as a percentage.
What Does It Mean? Your operating profit margin ratio shows you how much money youre making from your core business activities. Operating profit measures how much youre making after you pay for selling, general and administrative (SG&A) expenses, Richards says. You can compare these ratios to other companies in your industry to see how you stack up, and use the comparison to determine areas for improvement.
How to Calculate Operating Profit Margin:
Operating Profit ÷ Net Sales or Revenue
Sales are 100%. If your gross profit margin is 60% of sales and your SG&A expenses are 45% of sales, then your operating profit margin is 15% of sales.
Financial Ratio #4: Accounts Receivable Turnover
What Is It? This is an essential financial ratio for any business that bills clients as opposed to collecting cash at time of sale.
What Does It Mean? The accounts receivable turnover ratio indicates your ability to collect cash from credit customers. The higher the ratio, the faster your collections, Drake explains. But know your industry standards. If your ratio is too high, it could mean your credit is too tight. And that could mean loss of potential customers.
How to Calculate Accounts Receivable Turnover:
Net Credit Sales ÷ Average Accounts Receivable
Average accounts receivable is an average of your last two years of accounts receivable balance divided by two.
Financial Ratio #5: Days Sales Outstanding or In Receivables
What Is It? This ratio is an assessment of how much of your money is still uncollected and by how much. It works hand in hand with the accounts receivable turnover ratio and is expressed as days.
What Does It Mean? This shows how quickly clients are paying you. If your normal credit terms are 30 days and you calculate a ratio that tells you the number of days sales in receivables is 45, then you have some collections work to do, Drake says.
How to Calculate In Receivables:
365 (days in the year) ÷ Accounts Receivable Turnover Ratio
Other Financial Ratios
Different companies and industries have more specific items that they should be measuring, says Richards. Consider establishing measurements for key performance indicators KPIs that are important to your business, and track how you perform over time. KPIs may measure customers, products, operations, selling/marketing, and anything that you use to gauge your financial health.
Finance and accounting professionals with experience in your industry can tell you what other ratios and KPIs are relevant to your particular business. Trade associations also are a reliable source for this kind of information.
How to Use Financial Ratios
Now that you know what the key financial ratios are, how can you use them?
The more information you have, the better you can manage your business, Drake says. It's not like weighing yourself daily or once a week, but check them every time your company puts together its financial statements. There's a saying in business that if you can measure it, you can manage it. Ratios are the measures.
For the management part, enlist the help of a CPA or financial advisor with operational experience, preferably in your industry. Many professionals can do the ratios, but when it comes down to actually managing the business, you should consult with financial experts who have direct operational experience building and managing companies, says Richards.
Still, dont leave it all to the pros, cautions Drake: It's your business. Ask your CPA for help determining which ratios are most relevant for your business and understanding the industry norm. But learning how to calculate, track and interpret your own financial ratios is a vital part of being a responsible and ultimately successful business owner.