Most business owners know the importance of keeping an eye on their company’s financials as part of running a financially-sound business. Fewer entrepreneurs understand the value of using financial ratios to gain greater insight into their company’s financial statements and ultimately assessing the health of their business.
What are financial ratios?
Financial ratios are calculations that use information from a company’s financial statements, such as the income and cash flow statements. Ratios turn raw numbers into information that you can use to manage your business better by providing insight into your business’s profitability or helping to spot any potential risk areas.
Freshbooks, the accounting software company in the article ‘The 7 Best Financial Ratios for a Small Business’ outlines how businesses can get the most from their financial ratios..
“Financial ratios show a snapshot of your company at a single moment in time. That’s helpful, but to make the most of your financial ratios, it’s best to look at trends. Track and compare the ratios over time, rather than calculating them once to try and determine if the results are good or bad.”
Here is a guide of 5 financial ratios your small business should be tracking.
1. Net profit margin
Formula: Net profit margin = net profit/sales X 100
Net profit is calculated by deducting all company expenses from its total revenue. It measures what percentage of sales generated is profit. A high net profit margin indicates that a business is keeping its costs well under control.
2. Gross profit margin
Formula: Gross profit margin = net sales – cost of goods or services sold/net sales X 100
While the net profit margin measures how much money is left over after paying expenses, the gross profit margin measures the profit after deducting the cost of goods sold from revenue (cost of making the product).
3. Operating profit margin
Formula: Operating profit margin = gross profit – operating expenses/revenue X 100
The operating margin measures the revenue after a company covers operating costs including wage and raw materials, but before paying interest or tax. It’s particularly useful for business owners as it calculates what the company is making from its core operations, and excludes any income that is not from its business activities.
4. Working capital or current ratio
Formula: Working capital ratio = current assets/current liabilities
The working capital ratio, also known as current ratio, is a good indicator of whether the business can meet its short-term obligations. According to Investopedia, a working capital ratio of 1 or higher means the business’ assets exceed the value of its liabilities.
5. Inventory turnover
Formula: Inventory turnover = cost of goods sold/average inventory
For retail businesses that need to keep track of stock, this ratio is useful for determining how efficiently the company sells inventory. It measures how many times your average inventory is sold in a certain period of time. This helps businesses to stock the right amount of inventory and avoid either product sitting in the warehouse or having “inadequate inventory, which leads to lost sales opportunities”.
