Is a net profit of $200,000 on an income statement good? Look at the ratios. If it's earned on sales of $600,000, it could be. But if sales were $2.5 million, then the ratio is certainly less appealing. More sales were needed to produce that result. In other words, net income of $200,000 is 33.3 percent on sales of $600,000 and only 8 percent on the $2.5 million sales figure. If used properly, financial ratios can become powerful tools in determining what's happening—and what will happen—in a business. So how can ratios best be used?
Here are a few examples:
- Tracking performance. Comparing the same ratios year-over-year, or even over a series of years, charts a progression pattern and helps you plan for the future. Even more valuable, is to compare those ratios to other businesses within the same industry. To help you do that, BizStats offers free industry statistics, benchmarks, and financial ratios for Corporations, S-corps, and sole proprietorships for various industries on this site. You can ask your accountant for comparative ratios as well. There are a number of ratios, and many will not affect the typical small business. In general, financial ratios fall into four categories: liquidity, efficiency, profitability, and solvency.
- Liquidity as a barometer of cash flow. Perhaps the most important metric is the liquidity ratio, which is sometimes referred to as the working capital ratio. Essentially, this ratio measures working capital. This is also the most common financial ratio, and it shows the ability of a business to quickly generate cash and pay its debts. For the business owner, this ratio can also serve as a first alert if the business has a problem.
- Current vs. quick liquidity ratios. The current ratio—current assets vs. current liabilities—measures short-term solvency, which is an important aspect of liquidity. For example, if current assets (including cash) are $100,000, and current liabilities are $50,000, that makes the current ratio 2:1. Paying off some of the liabilities with cash assets and changing the mix from current assets of $75,000 to current liabilities of $25,000, shifts the current ratio to a more favorable 3:1. A decline in current ratio points to an increase in short-term debt, a decrease in current assets, or a combination of both.
The quick ratio is also referred to as the acid test and gets to the nitty gritty of a business quickly. It subtracts inventory from current assets and then compares the figure to current liabilities. The quick ratio gives businesses a better picture of their ability to meet short-term obligations, since inventory can only be turned into cash once it's sold, which can take time. A stable current ratio with a declining quick ratio may indicate that too much inventory is on hand. A good acid test is a quick ratio of 1:1.
Monitoring your financial ratios on a regular basis offers insight into how effectively you're managing your business. While liquidity is among the chief financial ratios, there is a wide range that acts as indicators for the overall status of your business. In terms of profitability, for example, you might want to look at ratios such as:
- Sales growth. The percentage increase (or decrease) in sales between two time periods.
- Cost of goods sold (COGS) to sales. The percentage of sales used to pay for expenses which vary directly with sales.
- Gross profit margin. The leading indicator of how much profit is earned on your products, minus selling and administration costs.
- Selling, general & administrative expenses (SG&A) to sales. The percentage of selling, general, and administrative costs to sales.
- Net profit margin. How much profit comes from every dollar of sales.
- Return on equity. The rate of return on your investment in the business.
- Return on assets. A measure of how effectively assets are used to generate a return.
Sources: "The Importance of Financial Ratios," Minnesota Business; "Financial Ratios," Small Business Notes
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