What are the Five Key Financial Ratios for Small Business Owners
Small business owners often overlook the importance of financial ratios. Financial ratios, simply stated, are tools that turn a business’ raw numbers into information that can be used to determine and manage its financial health.
Ratios are used to measure the different areas of a business that define its health ¾ profitability, efficiency, liquidity, and solvency. Profitability is a business’s ability to make money; efficiency is its ability to effectively manage its assets and liabilities; liquidity is its ability to pay off short term debts; and solvency is its ability to pay off long term debts.
When compared to industry benchmarks financial ratios can be used to analyze trends, compare the business to competitors, and measure progress towards goals.
The following list examines five of the key ratios for a small business.
1. Net Profit Ratio
Net income ÷ Sales = Net Profit Ratio
This profitability ratio measures if a business’ activities are profitable. A net profit ratio of 10% means that for every dollar of sales a business generates, 10¢ was created for the owner.
2. Quick Ratio
(Current Assets – Inventory) ÷ Current Liabilities = Quick Ratio
This liquidity ratio measures a business’ ability to generate cash. Its ability to cover its short term debts. A quick ratio greater than 1.0 generally means the business is doing well.
3. Inventory Turnover Ratio
Cost of Goods Sold ÷ Inventory = Inventory Turnover Ratio
This efficiency ratio shows how quickly a business is selling its inventory. A higher ratio indicates that sales are good and that the business is effectively managing it inventory by having less of its assets tied up in inventory.
4. Debt to Equity Ratio
Total Liabilities ÷ Shareholders Equity = Debt to Equity Ratio
This solvency ratio measures the amount of debt a business uses to finance its assets. In other words, it shows if the company uses debt or equity financing. The larger the ratio, the more debt is being used instead of the business’ equity.
5. Return on Assets Ratio
Net Income ÷ Total Assets = Return on Assets Ratio
This profitability ratio is used to determine how effectively a business is using its assets to generate profits. The greater the ratio, the better a business is using its assets to make money.
Putting it All Together
Now that you’ve reached the end of this list of financial ratios, you may be asking, “How do I use them?” The best way to use ratios is to look at trends. Track and compare the ratios to industry benchmarks over time, instead of calculating them once to attempt to determine if the results are good or bad.
Bottom line, financial ratios tell a story. They show where a business has been and suggest where it’s headed. Using financial ratios helps a small business owner recognize successes and solve problems.
Help is Available
If you are an entrepreneur interested in obtaining more information about using financial ratios to manage your business more effectively, contact your local Wyoming SBDC Network advisor by clicking here for no-cost, confidential assistance.