Financial ratios are like a thermometer for various aspects of your business's health. By keeping an eye on these numbers, you can act quickly to mitigate potential risks and look into relevant elements of your books to make data-backed decisions that help drive up profitability.
While financial ratios on their own don't tell a full story, they act as a beacon to lead you to potential concerns. But you have to know what you're looking for, which is why we've put together a quick primer on the top 10 financial ratios you can use to increase profitability and efficiency.
Ratios of Profitability
Profitability ratios help you understand whether your business is adding value to itself. The most basic definition of profitability comes from accounting textbooks: take revenues, subtract expenses, and you get profits.
While that number is obviously important, it doesn't tell a full story. If your profit is only $500, it sounds meagre, but what if your revenue was $600 and your expenses only $100? That's an enormous margin.
Profitability ratios help you see this bigger picture. Here are three ratios to consider.
- Gross profit margin, which is gross profit divided by sales. It's a basic determination of the balance of resources versus how much you make. When the ratio dips below one, it means you put more money into a product than you sell it for.
- Operating profit margin, which is operating income divided by sales. This is a good ratio for comparing the operating efficiency of multiple businesses because it takes out some financial factors such as debt.
- Net profit margin, which is net income divided by sales. This ratio takes all expenses into account.
Ratios of Liquidity
You might make a decent profit but have poor liquidity, and that can be a dangerous precipice. Poor liquidity means you're not in the best position to meet your short-term financial obligations, and you might be at risk for insolvency if an unplanned cash-heavy expense arises.
Here are two liquidity ratios.
- Current ratio, which is the value of your current assets divided by the value of your current liabilities. A current ratio of 2, which is advisable for many businesses, means the value of your assets is double the value of your liabilities.
- Quick ratio, which is the value of your current assets minus inventory divided by the value of your current liabilities. Many companies shoot for a ratio between 0.5 and 1, which is a healthy territory that makes it likely you'll be able to cover all your short-term obligations.
Ratios Related to Operations
Operating ratios measure the performance of various areas of your business so you can tell if resources are doing their jobs or if you have potential issues such as overstocking, bottlenecking or poor ROI.
Here are three operating ratios to consider.
- Inventory turnover ratio, which is the cost of goods sold divided by the value of your inventory. This ratio helps you understand if you have too much inventory on hand.
- Sales to receivables ratio, which is net sales divided by net receivables. This number lets you know how your AR is performing — specifically, how well and how fast your business collects AR.
- Return on assets ratio, which is net income before taxes divided by the total value of assets. This is another comparison tool that helps you see if a business is as efficient as its competitors at putting assets to work.
Ratios of Solvency
Solvency ratios help you understand if your business is in a good position to remain solvent. It looks at factors such as net worth and debt to give you an idea of whether you have enough value in your assets and cash reserves to maintain current business processes for any length of time.
Here are two solvency ratios.
- Debt-to-worth ratio, which is the total value of liabilities divided by net worth. This ratio lets you quickly see whether you're carrying a high amount of debt proportionate to your business.
- Working capital, which is the total value of current assets minus the total value of current liabilities. In short, this is the amount of cash value you could get from your business if you liquefied everything, covered debts and counted what was left. Working capital is often considered when businesses seek investors or loans.
Get Your Financial Ratios Now
Check out the financial ratios calculator, which lets you enter a few numbers about your business finances and generate a report that provides all of the financial ratios above with commentary on where you want the numbers to be.