Whether large or small, all businesses rely on technical data to measure their performance. Financial ratios in particular can easily communicate if a business is struggling. Accountants similarly both calculate and analyze these financial ratios to advise clients on how to improve their financial activity.
By understanding how these ratios work and what they communicate, you will be able to more easily pinpoint points of friction within your business. These are some of the more frequently used financial ratios but many can be analyzed to better understand the current standing of your business.
As you read on, remember that your accountant can help you with those ratios that are particularly important to understanding the health of your business.
The following are some beginning financial ratios to help your understand your business better.
Gross Profit Margin
Profit margin on sales, or gross profit margin, evaluates how much a business produces in net income per every dollar in sales. The profit margin on sales financial ratio is used to observe a business’s profitability during a specific time frame.
[Revenue minus cost of goods sold] / [Revenue] = Gross Profit Margin
There are many ways you can use this ratio. You can use it to determine whether your profit margin is within range for your industry. You can also use it to determine whether additional expenses you take on (like labor or equipment) are helping you produce more revenue.
Asset Turnover indicates how successfully a company utilizes all of its assets to effectively promote profits.
[Net sales] / [total assets] = Asset Turnover
This ratio can be used for a business looking to scale back or assess how well their current assets help produce sales,
Accounts Receivable Turnover
Number of days’ supply in average receivables, an activity-based financial ratio, quantifies the necessary amount of days for the collection of receivables.
 / [Receivables turnover] = Accounts Receivable Turnover
When a business is struggling, the company’s leaders can decide based on the number of days’ supply in average receivables ratio which accounts can continue to make purchases on account.
Cash to Debt
If a business is struggling due to debt-related issues, the cash debt coverage ratio can quickly determine the company’s risk of insolvency.
[net cash provided by operating activities] / [average total liabilities] = Cash to Debt
Since the cash debt coverage ratio forecasts within a year, a business owner can conclude with this financial ratio whether or not a business can reimburse creditors via the company’s operational activities.
Inventory Turnover signifies how often a business sells its inventory to produce profits. As the inventory turnover ratio increases, it represents a business’s efficiency in terms of purchasing new inventory and selling old inventory.
[Cost of Goods Sold] / [(beginning inventory + ending inventory)/2] = Inventory Turnover
A company should focus on this ratio in particular if its inventory has high risks of spoilage, obsolescence, or other similar issues. For example, a grocery store may have a higher inventory ratio than a car dealership. Very different industries but the grocery store inventory is likely to spoil and be outdated much quicker than the vehicles at the dealership.
This financial ratio means that a corporate enterprise heavily distributes its earnings as cash dividends. Conversely, a small payout ratio implies that most earnings serve as finances for future investments.
[Cash dividends] / [net income] = Payout Ratio
Your payout ratio will likely change over time – and should! Typically a small payout ratio is common in the early years of a business and should grow as the business matures.
Return on Equity
Return on equity, also known as the rate of return on common stock equity, denotes how profitable the owners’ investment currently remains.
[Net income – preferred dividends]/[average common stockholders’ equity]
A larger return of equity means a larger efficiency in profit production. Moreover, you can interpret the return on equity as the return on assets with fewer liabilities because shareholders’ equity is the same as net assets.
Making Financial Ratios Work for You
Assessing the financial position of your business should go beyond reviewing your financial statements. Performing analyses to dive into the numbers and see how they change over time can provide further information on how your business is progressing.
While you can use these financial ratios to give you a deeper insight into your financial position, it can be beneficial to analyze these ratios with your CPA. From there you can have conversations about future KPIs, creating financial strategies, and how to build your business stronger.
To better analyze your business’s financial position, consider sending us a message to reach our accountants and see how we can help you.