When managing any business, there are a number of key variables to calculate and monitor Finance is a core pillar of the business that needs to be managed successfully. Usually, we see that finance is not an easy area for management. One way to manage your finance successfully is to perform a ratio analysis. If calculated and interpreted right, financial ratios can provide you with a clear picture of the business affairs and flag areas that need management’s intervention.
This article will explore seven key ratios that every small business owner needs to know.
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Financial ratios are essentially mathematical formulae that can help you to convert the numbers on your financial statement into useful information. With this information, it is easy to evaluate business performance.
So now the question is which financial ratios should the management of small businesses focus on when there are hundreds of financial ratios. Below are seven ratios that a small business owner must know and focus on.
Commonly called the Acid Test ratio, the quick ratio determines your ability to pay off your business debts. The quick ratio accounts for your liquidity, and by comparing it to your liabilities lets you know how much leeway you have in spending.
Quick Ratio = (Cash & Cash Equivalents + Marketable Securities + Accounts Receivable) / Current Liabilities
If the quick ratio is over 1.0, your business is doing fine. The higher the ratio the better. With a good quick ratio, you can safely invest in further business ventures without worries of going into debt should it fail. This ratio is an excellent marker to track your business performance.
Return on total assets:
This ratio evaluates the ability of your assets to generate a profit. It basically compares your invested assets with your earned income to measure efficiency.
Return on total assets = net income/average total assets
The higher this ratio gets, the better your economic resource usage is. Comparing your Return on Total Assets ratio with competitors in the market is a good way to gauge the return on your investments. Similarly, calculating this ratio yearly and comparing it with each subsequent year can help assess growth. If the ratio rises then your resource use is getting better, but if it falls, something needs to be fixed.
Operating cash flow to net sales ratio:
This ratio compares the operating cash flow (OCF) with net sales to gauge a business’ ability to generate cash flow in proportion to its sales volume. OCF is the cash generated by a company’s regular business activities over a period.
Operating cash flow to net sales ratio = operating cash flow/net sales
Ideally, this number should stay the same as sales increase, otherwise, it indicates problems in the cash flow of the business.
Working capital ratio:
Also called the Current ratio, this ratio informs us of the business’ ability to pay short-term debts. If this ratio is higher than 1, it means the company’s assets out-value its liabilities. This ratio should always be above 1 for stable and liquid operations.
Working capital ratio = current assets/current liabilities
Inventory turnover ratio
This ratio compares the cost of goods sold with the average inventory at hand. It basically evaluates the business’ inventory management capability.
Inventory turnover = cost of goods sold/average inventory
We can compare this ratio with competitors to assess how efficient our inventory cycle is. If the ratio is higher than the industry benchmark, it means your inventory management is better compared to most competitors.
Net profit margin:
The net profit margin shows us how much of each dollar of revenue is translated into profit. The higher the percentage, the better.
A poor or deteriorating NP margin may be an indicator of operational inefficiency in the business.
Net profit margin = net profit/sales X 100
Gross profit margin:
The gross profit margin indicates how much profit is left after deducting the cost of goods sold from the revenue. The higher the percentage, the better.
Gross profit margin = net sales – cost of goods or services sold/net sales X 100
A poor or deteriorating GP ratio may be an indicator of issues in sales & marketing, procurement or inventory management.
By calculating and analysing ratios, you can gain a deeper insight into your business affairs and be able to flag areas that warrant management’s intervention. While financial ratios are used mostly by SMEs and bigger companies, these are equally important for smaller businesses.
According to the Unites States Small Business Association, businesses that perform weekly evaluations are 90-95% more likely to succeed than companies that do it less frequently or do not do it at all.
This clearly shows how important is ratio analysis for a business – especially a small business – from a strategic point of view.
However, it is important to understand here that ratio analysis is not a mathematical exercise and not everyone can interpret ratios and propose remedial actions right.
Unless you have in-house experts who can calculate relevant ratios, interpret them right and propose valid remedial actions, you better hire this service.
Is this service available?
In 2022, outsourcing finance has become widely popular and profitable. Outsourcing companies usually perform ratio analysis as part of this service to advise remedial initiatives to the management.
Where will I find high-quality but affordable financial analysis service?
Whenever you are hiring a service, it is important to check whether it is value-for-money. Expertise Accelerated (EA) is a Connecticut-based outsourcing and staff augmentation specialist for accounting & finance services, and it is led by Haroon Jafree (CPA) who is a turnaround, trade spend management, business process reengineering, and cost optimization expert.
Expertise Accelerated’s Financial Planning & Analysis Services for small-and-medium-sized businesses are affordable and of a high-quality and are aimed at helping owners of such businesses to scale and grow amid the prevailing challenging business environment.