This article is for educational purposes and does not constitute legal, tax, or financial advice. For specific advice applicable to your business, please contact a professional.
If you are a business owner, having a good working knowledge of business formulas could help you stay organized and more closely manage your cash flow. There are a plethora of financial ratios business owners may want to consider analyzing to check on the overall health of their business. Below are a few you might want to check regularly.
What is a Financial Ratio?
Financial ratios are one of many tools business owners can use to gain insights into their business. Different ratios can offer visibility into how profitable, efficient, or liquid a business is, for example. Often these financial ratios are calculated by plugging in values from bookkeeping forms like a balance sheet, income statement, and cash flow forecasting statement.
While these are not the only types of financial ratios to consider, there are a few ways you can group these financial ratios:
- Financial ratios that measure liquidity: Liquidity ratios include ratios like a quick ratio, working capital ratio, free cash flow ratio, or cash ratio. These ratios determine a business’s ability to cover short-term obligations and cash flow.
- Financial ratios that measure efficiency: Efficiency ratios include ratios like revenue per employee, return on total assets, and inventory turnover ratios. These ratios measure a business’s ability to use its own assets to generate income.
- Financial ratios that determine solvency: Solvency ratios include equity ratios and debt-to-equity ratios. These ratios measure a business’s ability to meet long-term debt obligations and are often used by lenders.
- Financial ratios that measure profitability: Profitability ratios include net profit margin ratios, return on total assets, and return on equity ratios. These ratios are a way to assess a business’s ability to generate earnings based on its sales, operations, balance sheet assets, and shareholder’s equity. They are closest to efficiency ratios as they consider assets as a way to generate income.
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Net Profit Ratio
Determining your net profit ratio or net profit margin can help you make decisions related to your business, from pricing goods and services to opportunities for reinvestment. Net profit represents the amount of money your business has after your expenses are paid or accounted for. This can also be referred to as net income or net earnings.
Net profit/Net Sales = Net Profit Ratio
Gross Profit Margin Ratio
Although gross margin ratios and net profit ratios are similar, there are some differences. While both are profitability ratios, gross profit shows the percentage of revenue that exceeds the cost of goods sold.
(Revenue - Cost of Goods Sold)/Revenue = Gross Profit Ratio
This ratio shows you the amount of money the business has on hand after subtracting the cost of goods sold. Both the net profit and gross profit formulas can be used to calculate net profit margin and gross profit margin.
Inventory Turnover Ratio
An inventory turnover or inventory turnover ratio refers to the rate at which inventory is being used or consumed over a period of time. As a business owner, this is a way to track how many times you are selling and replacing inventory in order to better forecast how much you might need. There are several ways you can calculate this ratio. Below is an inventory turnover formula to consider:
Cost of Goods Sold/Average Value of Inventory = Inventory Turnover Ratio
Using your balance sheet and income statement, you can identify your cost of goods sold number to use within the formula above. Keeping track of your inventory turnover ratio can help you see the ebbs and flows of inventory. This can help you better predict how much inventory to keep in stock over a particular period of time. An inventory turnover ratio may uncover that your business is holding inventory for too long, also known as obsolete inventory, or that a particular type of inventory is frequently out of stock. In the case of obsolete inventory, a business is holding on to inventory that it may not be able to use or sell due to a lack of demand. After a certain amount of time passes it goes from being slow-moving inventory to excess inventory before finally becoming obsolete.
A quick ratio, also known as an acid test ratio, is a way to measure your business’s liquidity. Business owners can use a quick ratio calculation to measure if the business can cover costs and make future payments. Here is a sample formula for calculating a quick ratio:
(Current Assets - Inventory)/Current Liabilities = Quick Ratio
The assets in this formula are assets and cash the business has on hand that could be quickly converted into cash. Assets that can be easily converted to cash are also referred to as liquid assets. As you are calculating a ratio that factors in assets and liabilities, you can find the values for this ratio in your company’s balance sheet.
If you are a business with debt, a debt-to-equity ratio can help you see if your debt is high relative to your business. In this equation, debt represents all the liabilities your business owes to other businesses, employees, or the government and equity represents the ownership or value of your business. This is a way to assess if your business’s debt and equity could pose a financial risk to your business.
Total Debt/Total Equity = Debt-to-Equity Ratio
You can find your equity in your balance sheet or calculate it by subtracting your liabilities from assets. Debt is found by adding your long-term debt, short-term debt, and fixed payments.
These financial ratios are just a few to consider when looking to better measure your business’s profitability, cash flow, and efficiency. While one financial ratio alone can’t give you a complete picture of your business’s financial performance, uing these ratios can give you better awareness of potential opportunities.