As a small business owner, you work hard to make your company successful. When problems come up, you face them head-on to push your business forward. Whether you go an inch or a mile, you record all your financial moves in your small business online accounting records.
If you simply write down your transactions, you could miss key information about your financial fitness. You need financial ratios to measure your momentum.
Why look at financial ratios for small business?
Financial ratios help make sense of your accounting information. Ratios show you what aspects of your business are efficient (and what’s not working) by comparing figures.
Ratios compare your present conditions to past performance. They help you identify your gains and weaknesses. By looking at trends in your strengths and shortcomings, you can improve business operations.
Financial ratios also compare you to other companies in your industry, so you can see how you stack up against your competitors. Lenders look at ratios when you apply for a loan.
Statements to use
Many ratios come from two financial statements: the balance sheet and the income statement.
- The balance sheet shows your business’s net value. It includes your assets, liabilities, and equity.
- The income statement includes all the money coming in and out of your business. It shows how you use assets and liabilities.
Small business financial ratios
Take a look at the following six financial ratios to use in your business.
1. Common size ratio
The common size ratio helps you compare one aspect of your accounting to the big picture of your finances. You calculate each line item as a percentage of the total amount on the statement.
Common Size Ratio = Line Item / Total
Common size ratio for cash is 2.5% because:
$500 cash / $20,000 total = 0.025
0.025 X 100 = 2.5%
You can use the common size ratio with your balance sheet or income statement. For example, you can find the percentage of assets you have on the balance sheet. You can see your business’s percentage of sales made on the income statement.
2. Current ratio
A current ratio shows your present financial strength. It represents how many times bigger your current assets are compared to your current liabilities. This is also called a working capital ratio.
Current Ratio = Total Current Assets to Total Current Liabilities
|Line of Credit||$10,000|
Current ratio is 2 to 1 because:
$20,000 current assets to $10,000 current liabilities = 2 to 1
A 2 to 1 ratio is healthy for your business. This means you have twice as many assets as liabilities.
3. Quick ratio
A quick ratio shows if you can meet financial obligations, even if something unexpected happens. For example, if you own a floral shop, would you be able to handle unanticipated maintenance costs on your delivery truck?
Quick Ratio = (Total Current Assets – Total Current Inventory) / Total Current Liabilities
|Line of Credit||$10,000|
Quick ratio is 0.5 because:
($20,000 current assets – $15,000 current inventory) / $10,000 current liabilities = 0.5
A healthy quick ratio is 1.0 or more.
4. Inventory turnover ratio
An inventory turnover ratio reveals the how frequently you convert inventory into sales. It shows how much product is sold and how efficiently you manage inventory.
Inventory Turnover Ratio = Cost of Goods Sold / Average Inventory
|Cost of Goods Sold||$1,750|
Inventory turnover ratio is 1.16 because:
$1,750 cost of goods sold / $1,500 average inventory = 1.16
The greater the inventory turnover ratio, the more frequently inventory converts into cash. A greater inventory turnover ratio is good for business because it reflects greater sales.
5. Debt-to-worth ratio
The debt-to-worth ratio shows how dependent you are on borrowed finances compared to your own funding. It compares how much you owe to how much you own. What is business net worth and total liabilities for your company? You’ll need to know these figures before calculating your debt-to-worth ratio.
Debt-to-Worth Ratio = Total Liabilities / Net Worth
|Line of Credit||$5,000|
Debt-to-worth ratio is 1 because:
Note: Net worth = Assets – Liabilities
$10,000 total liabilities / ($20,000 – $10,000 net worth) = 1
If the debt-to-worth ratio is greater than 1, your business has more capital from lenders than you. If you are trying to get an SBA loan, or any loan for that matter, the bank might see this as a risk.
6. ROI (return on investment)
ROI compares the amount of money an investment brings into your business to how much you paid for the investment. This ratio shows the money you invest and the profit you get back from it.
ROI = (Earnings – Initial Cost of Investment) / Initial Cost of Investment
|Initial Cost of Investment||$7,500|
ROI is 1.67 because:
($20,000 earnings – $7,500 initial investment) / $7,500 initial investment = 1.67
The higher your ROI, the more your investments turn into income.
Financial ratios for your small business
The numbers in your accounting books tell a story. They show where you’ve been and suggest where you’re headed. Using ratios to compare financial numbers helps your business recognize successes and solve problems.
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This article has been updated from its original publication date of February 18, 2016.This is not intended as legal advice; for more information, please click here.