As a small business owner, it’s important to be aware of the financial health of your business. One of the most powerful tools to help you analyze your business’s health is financial ratios. These ratios provide you with valuable insights into the performance, profitability, and overall financial stability of your business.
Nolan Accounting can help you track the financial ratios of your Southeast Wisconsin business. We work with businesses across Milwaukee, Greenfield, New Berlin, Muskego, West Allis, Waukesha, and the surrounding areas.
In this article, we’ll explain some of the most common financial ratios that you can use to evaluate the health of your business.
Top 5 Financial Ratios
The finances of your small business tell the story of the health of your business. Below are the top 5 financial ratios that you can use to analyze your business’s health:
Liquidity Ratios
Liquidity ratios reveal the ability of the business to meet its short-term financial obligations, which indicates overall financial stability. The most common liquidity ratios include:
- Current Ratio: calculated by dividing current assets by current liabilities. This will measure the ability of the business to cover short-term obligations. If the ratio is above 1, the business is in a healthy financial position.
- Quick Ratio: also referred to as the acid-test ratio and is more stringent than the current ratio. This excludes inventory from current assets since it may not be easily converted into cash. A ratio of 1 or higher is usually considered favorable.
Profitability Ratios
Profitability ratios reveal the ability of the business to generate profits in relation to revenue and assets. These are critical for understanding the sustainability of the business. Key profitability ratios include:
- Gross Profit Margin: represents the percentage of the revenue that remains after subtracting the cost of goods sold. This offers insights into pricing strategy and cost efficiency.
- Net Profit Margin: measures the percentage of net income in relation to total revenue, offering a comprehensive view of the overall profitability of the business.
- Return on Assets: ROA evaluates how efficiently the business is using its assets to generate profits. This is calculated by dividing net income by total assets. The higher the ROA, the better the asset utilization.
- Return on Equity: ROE measures the return on shareholder investments. Investors prefer a higher ROE.
Solvency Ratios
Solvency ratios assess the long-term financial stability and ability of the business to meet long-term obligations. Creditors and investors are especially interested in these ratios, which include:
- Debt-to-Equity: calculated by dividing the total debt of the business to the shareholder’s equity. It indicates how reliant the business is on debt financing. A lower ratio is more favorable.
- Interest Coverage: indicates the ability of the business to meet interest payments on outstanding debt. This is calculated by dividing earnings before interest and taxes by interest expense. A higher ratio suggests a healthy financial position.
Efficiency Ratios
Efficiency ratios, also referred to as activity ratios, measure how effectively the business is using its assets and resources. These are critical for assessing the operational efficiency of the business.
- Inventory Turnover: assesses how quickly a company sells its inventory and is calculated by dividing the cost of goods sold by the average inventory. A higher ratio indicates efficient inventory management.
- Accounts Receivable Turnover: evaluates how efficiently the business collects payments from customers. This is calculated by dividing total sales by average accounts receivable. A higher ratio indicates effective management.
Growth Ratios
Growth ratios indicate the potential for expansion and long-term sustainability. These ratios are often used by investors to assess future prospects. These ratios include:
- Earnings-per-share: EPS evaluates the profitability of the business on a per-share basis. This is calculated by dividing net income by the number of outstanding shares. This is often used by investors to assess the earning potential of the business.
- Price-to-Earnings: P/E compares the stock price of the business to its earnings per share. This helps the investors to determine whether the stock is under- or over-valued in the market.
Let Nolan Accounting Manage Your Small Business Finances
Financial ratios are critical to use when you analyze your business’s health. They offer insight into the liquidity, profitability, solvency, efficiency, and growth potential of your business. Business owners, investors, and lenders can use these ratios to make decisions regarding investments, loans, and strategic planning.
As a business owner, you have a lot to deal with, and may not have as much time to spend on financials as you’d like. Let Nolan Accounting manage your small business finances. We can help you stay on top of these ratios and quickly see the financial health of your small business.