Why is it important to measure and track financial ratios?
Measuring and tracking financial ratios is important because they provide insight into whether your business is financially healthy and running efficiently. Financial ratios reveal information that can help you spot problem areas – maybe you've accumulated too much debt or not collected receivables fast enough – and identify where there's room for improvement.
What are the most important financial ratios for small businesses? This guide covers key financial ratios and how to calculate them.
What are financial ratios?
Financial ratios are calculations that turn raw numbers into insightful data that shows how your business is performing. They're classified as a type of key performance indicator (KPI) and draw information from your financial statements. Each financial ratio consists of more than one financial figure.
Why are financial ratios important in business?
Financial ratios are important in business because they help you evaluate how your business performs over time. With financial ratios, you can dig below the surface of your finances into target areas that require improvement, like cash flow, profit and operational efficiency.
You can also use ratio analysis to compare how your business performs compared to other companies in your industry. If you're seeking business finance from a bank or investor, financial ratios provide those stakeholders with proof your business can afford the repayments or produce a solid financial return.
Financial ratio categories
Financial ratios fall into 6 broad categories: efficiency, liquidity, leverage, profitability, market value and coverage ratios.
Efficiency ratios
Efficiency ratios, or activity ratios, measure how efficiently your business uses assets and liabilities to generate sales and profits.
Key efficiency ratios include inventory turnover, payables turnover, accounts receivable turnover and asset turnover ratios.
Liquidity ratios
Liquidity ratios calculate whether you can pay off any short-term debts as they're due using your current assets.
Key liquidity ratios include the current, quick and working capital ratios.
Leverage ratios
Leverage ratios, also called solvency ratios, compare your business's debt levels with your assets, equity and earnings. Analysing these ratios will help you gauge how likely your business is to 'stay afloat' long-term by paying off long-term debt and any accumulated interest.
Key leverage ratios include debt-to-equity, debt-to-assets and interest coverage ratios.
Profitability ratios
Profitability ratios evaluate business performance based on income – how well you generate profits relative to revenue, assets, operating costs or shareholder equity – over a certain period.
Key profitability ratios include net profit margin, return on assets, return on equity, return on capital employed and gross margin ratios.
Coverage ratios
Coverage ratios measure whether you can service your debt obligations, including interest payments. The higher the ratio, the easier you can make the necessary repayments.
Key coverage ratios include times earned interest ratio and debt-to-service coverage ratio.
Market value ratios
Market value ratios show the current share price of your stock (if you're a publicly-held company). Current and potential investors often use these ratios to determine whether your shares are overpriced or undervalued.
Key market value ratios include price/earnings ratio, market value per share, earnings per share, dividend yield and book value per share.
6 best financial ratios to track for small businesses
You can analyse many ratios, but the six best financial ratios to track for small businesses are quick ratio, debt-to-equity ratio, working capital ratio, gross profit ratio, inventory ratio and return on equity ratio.
Here's why each ratio is important – and how to calculate them:
1. Quick ratio
The quick ratio – or 'acid test' – is a ratio that measures liquidity, specifically whether you have enough current assets to cover current liabilities, like short-term loans, payroll tax, income tax and other accrued expenses.
Here's the formula for calculating your quick ratio:
(Current Assets-Inventory-Pre-paid expenses) ÷ Current Liabilities = Quick Ratio
Even though inventory is considered a current asset, it's typically excluded when calculating quick ratio because it can take some time to convert to cash.
The higher the quick ratio, the better you can cover your current liabilities. Usually, if your quick ratio is below 1, your debts are more significant than your assets – this is a sign you need to pay down debt faster, or you may be experiencing cash flow problems.
2. Debt to equity ratio
The debt to equity ratio indicates how much debt a business carries compared to owner investment. Also referred to as a leverage ratio, this ratio determines financial risk – the more debt compared to equity your business is using to fund operations, the more highly leveraged your business is.
The debt to equity formula is:
Debt to Equity Ratio = Total Liabilities ÷ Shareholders’ Equity
3. Working capital ratio
The working capital ratio is a basic liquidity metric – how quickly you can turn your assets into cash. Also known as the current ratio, the working capital ratio indicates how capable your business is of meeting its current financial obligations. The numbers for calculating your working capital ratio can be found in your financial statements, specifically the balance sheet.
Use this formula to find your working capital ratio:
Working Capital Ratio = Current Assets ÷ Current Liabilities
4. Gross profit margin
Gross profit margin is the percentage of revenue you have left over after deducting the cost of goods sold. This ratio shows how much you spend per product (not including production or manufacturing costs), which can help you price your products more accurately.
To calculate gross profit margin, use this formula:
Gross Profit Margin = (Revenue - Cost of Goods Sold) ÷ Revenue
Subtract cost of goods sold from your revenue – this will give you your gross profit as a dollar figure.
Divide that number by your total revenue.
Multiply by 100 to get the gross profit margin.
5. Inventory turnover
Inventory turnover measures how well you manage inventory, specifically how often your business sells its average inventory in a financial year. While economic order quantity (EOQ) tells you how much inventory you need to order, and inventory days predict how long that stock will last, inventory turnover reveals if your inventory is in demand – or if your carrying costs are sitting too high.
The formula for inventory turnover is:
Inventory Turnover = Cost of Goods Sold ÷ Average Inventory
6. Return on equity
Return on equity (ROE) is a profitability ratio that shows how well your business generates profit from its equity. What's considered a good ROE changes across sectors and industries, but generally, higher is better. A high ROE illustrates that your business successfully converts its equity financing into profits.
Here's the formula:
Return on Equity = (Net Income ÷ Average Shareholders' Equity) x100
Financial ratio FAQs
What are the four solvency ratios?
Four key solvency ratios are debt-to-assets ratio, interest coverage ratio, equity ratio and debt-to-equity (D/E) ratio. When you compare these ratios with liquidity ratios, you can see whether your business can pay its short and long-term debts and financial obligations.
Debt-to-assets ratio measures the portion of total assets financed by debt.
Interest coverage shows if your business can cover its interest expenses with its earnings before interest and taxes.
Equity ratio calculates the value of the assets financed using the owner's equity.
Debt-to-equity compares total debt and total equity.
What is considered a good liquidity ratio?
Anything higher than 1 is a good liquidity ratio, although generally, the higher the ratio, the better. For creditors and investors, it shows your business can pay its short-term bills. If your liquidity ratio is below 1, this is a sign your business's current liabilities exceed your current income and assets.
What is considered a good return on equity?
By and large, 15-20% is considered a good return on equity (ROE), but this benchmark may be lower or higher depending on your business sector.
What is the difference between ROI and ROE?
There are several differences between return on investment (ROI) and return on equity (ROE). ROI measures the gain or loss generated on a specific investment and is a measure of the efficiency of the investment.
On the other hand, ROE looks at how effectively a business manages shareholder and investor contributions to generate profit and grow the business. ROI can be applied to any type of investment, while ROE is specific to companies and how they use equity financing.
Fast, accurate financial ratio analysis
Financial ratios provide a snapshot of business performance at a particular point in time. By crunching these numbers, you and your team can focus on the specific areas of the business that need improving or optimising. For lenders and investors, the information they can glean from financial ratios helps them make informed decisions about your business.
With MYOB Business AccountRight Plus and Premier, you have financial reporting tools built in. You can also integrate Analysis One, which has features that automate the calculation of those all-important ratios, making the analysis process faster and more accurate. Get started today.
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