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Using Accounting Ratios to Understand Your Business

As you build a small business, it’s important to measure your company’s financial health. That’s where accounting ratios come in—these calculations help you make sense of your accounting figures. Measuring them regularly gives you a clear picture of your debt, income, and operating costs, so you can make informed business decisions.

Using Profitability Ratios to Measure Business Efficiency

Profitability ratios compare different accounts to see how efficiently your business is generating profits. In other words, these ratios tell you how well your operations are bringing in income. If you’re planning to seek funding from creditors or investors, expect to provide this type of financial performance data—these ratios explain your company’s ability to continue operating as it is.

Gross Margin Profitability Ratio

This ratio compares your company’s gross margin, or your total sales revenue minus cost of goods sold, to your net sales, or sales after rebates, returns, and other allowances. It tells you the profits your company earns from selling products or services. To calculate the gross margin ratio, follow this formula:

  • Gross margin ratio = (revenue – cost of goods sold) / revenue

That means if your company has $500,000 in revenue and $200,000 in costs of goods sold, you calculate your gross margin profitability ratio as ($500,000 – $200,000) / $500,000 = 60%.

Compare your gross profit margin to the industry average. A higher margin indicates your business stands to make a reasonable profit, while a lower margin could suggest under-pricing of your goods. Keep in mind the gross margin ratio is not the same as the profit margin ratio. Gross margin only considers the cost of goods sold as an expense, while profit margin considers other expenses.

Profit Margin Profitability Ratio

The profit margin ratio measures the amount of net income, or income after expenses, your company earns with each dollar’s worth of revenue. It tells you the percentage of sales that remain after you pay all of your company’s expenses. The higher the ratio, the better. To calculate your profit margin ratio, divide your net income by your net sales.

  • Profit margin ratio = net income / net sales

So, if your company has $500,000 in revenue, $200,000 in cost of goods sold, and $150,000 of other expenses, the profit margin ratio is ($500,000 – $200,000 – $150,000) / $500,000, or 30%.

Comparing your profit margin ratio to the industry average indicates how well your company stacks up against competitors. A higher ratio signifies that your business is practicing effective cost control.

Return on Assets Profitability Ratio

This ratio measures the net income your company’s total assets produce over a period of time. It tells you how efficiently your company uses its assets to generate profits. To calculate your return on assets ratio, divide your net income by your average total assets.

  • Return on assets = net income / average total assets

For example, imagine your company has $100,000 in net income over the year. Your beginning assets were $500,000, and your ending assets are $600,000. Your return on assets is $100,000 / $550,000, or 18.2%. This means that every dollar you invest in assets produces 18.2 cents of profit.

When it comes to return on assets, the higher the ratio, the more profit for your company.

Return on Capital Employed Profitability Ratio

This ratio measures how efficiently your company can generate profits from the capital you use. It takes into account both equity, or the difference between total assets and liabilities, and long-term liabilities, so it tells you about your profitability over time. Instead of net income, the ratio uses operating profit, which is often called earnings before income and taxes (EBIT). The formula is:

  • Return on capital employed = EBIT / (total assets – current liabilities)

As you calculate this ratio, your goal is to increase your ratio value. If your ratio is 0.25, it means that your business generates 25 cents for every dollar of combined equity and long-term liabilities. Compare this ratio to the rate at which you’re borrowing. You always want the return capital ratio to be higher than the borrowing rate.

Return on Equity Profitability Ratio

Like the return on capital employed ratio, return on equity shows how your company generates profits from your investors’ capital. This tells you how much profit each dollar of stockholders’ equity generates and illustrates how well you’re using your investors’ money. The formula for this ratio is:

  • Return on equity = net income / equity

For example, imagine your net income is $600,000 and your stockholders’ equity is $2,000,000. Your return on equity is $600,000 / $2,000,000, or 30%. A ratio of 14% is generally considered acceptable, while anything less than 10% is regarded as poor.

Analyze Your Business Using Coverage Ratios

Coverage ratios help you examine your small business’ finances and determine if it can maintain operations, stay alive, and continue to grow. These ratios help you understand your debt, so you can tell if you have a healthy amount or if you’re overextended. They also tell you about your company’s ability to service debt and other financial obligations and let you know how well your company can afford to make its interest payments. It’s a good idea to include coverage ratios in your regular financial reports—that way, you can make smarter business decisions and prevent heavy borrowing.

Times Interest Earned Coverage Ratio

The times interest earned ratio measures the amount of times your income can cover your company’s interest payments on your debt. The more profit your company generates, the more easily you can cover debt.

  • Times interest earned = EBIT / interest expense

For example, if your firm has an EBIT of $500,000 and an interest expense of $100,000, your calculation is $500,000 / $100,000, or 5. This means your company earns five times the amount you need to meet your debt obligations. The higher this ratio, the better. A value of lower than 1.5 typically indicates your company is having difficulty paying back your creditors.

Fixed Charge Coverage Ratio

The fixed charge coverage ratio measures your company’s ability to pay all of your bills and expenses, only using your income before interest or taxes. A fixed charge is any recurring charge, such as a lease payment, that remains fixed regardless of your operational activity. This ratio is an extension of the times interest earned ratio.

The formula for this ratio is:

  • Fixed charge coverage ratio = (EBIT + fixed charges before taxes) / (fixed charges before taxes + interest expense)

To expand on the example above, assume your company also has $75,000 in fixed charges before taxes. The value of the ratio is ($500,000 + $75,000) / ($75,000 + $100,000) = 3.29.

This shows your company generates 3.29 times more earnings than you need to cover your financial obligations. Lenders often use this ratio to analyze your financial health. The higher the ratio, the greater your company’s strength.

Debt Service Coverage Ratio

The debt service coverage ratio compares your company’s operating income to your total debt service costs. This measures your ability to service your current debts. This ratio takes into consideration all of your debt-related expenses, such as interest, principal, and pension obligations. Your creditors rely heavily on this ratio when they look at your company’s ability to meet all of your debt obligations.

To calculate the debt service coverage ratio, use this formula:

  • Debt service coverage ratio = operating income / total debt service costs

A higher ratio is always better. If your ratio is lower than 1, it means your company isn’t generating enough profits to service debt. In that case, you’re probably using savings to pay down your debt, and you may need to consider a debt management plan.

Using Efficiency Ratios to Measure Profitable Activities

Efficiency ratios, or activity ratios, show how well your business uses your assets and liabilities to bring in income. These ratios help you improve your operations. They also help investors and creditors understand your company. If you want to increase profits, it’s a good idea to measure these four ratios regularly.

Accounts Receivable Turnover Efficiency Ratio

The accounts receivable turnover ratio measures how many times your business can turn its accounts receivables into cash over a specific time period. A higher number means you’re more efficient. To calculate the accounts receivable turnover ratio, you need to know your net credit sales, which are net sales resulting from credit sales, and your average accounts receivable, which is the average balance of your accounts receivable for the period.

  • Accounts receivable turnover ratio = net credit sales / average accounts receivable

Imagine your net credit sales are $50,000 and your average accounts receivable is $15,000. The accounts receivables turnover is $50,000 / $15,000, or 3.33. This means that your business collects on receivables about 3.3 times per year.

Working Capital Efficiency Ratio

The working capital ratio, or current ratio, measures your company’s ability to pay off your current liabilities using your current assets. It is always better to have a higher value for this ratio. If your value is lower than 1, it means that your business can’t meet its short-term debt requirements. The formula for this ratio is:

  • Working capital ratio = current assets / current liabilities

If your working capital ratio is 3, it means your company has $3 available for every dollar in current liabilities. This indicates you’re in a healthy financial position.

Asset Turnover Efficiency Ratio

The asset turnover ratio measures how well your company can generate sales from your assets. To calculate this ratio, use the following formula:

  • Asset turnover efficiency ratio = net sales / average total assets

Assume your company has $250,000 in sales and $500,000 in average total assets. Your asset turnover efficiency ratio is $250,000 / $500,000, or 0.5. This means that each dollar of your assets creates 50 cents in sales. Generally, a higher asset turnover ratio is better for your company.

Inventory Turnover Efficiency Ratio

The inventory turnover ratio measures how effectively you manage your inventory over a period of time. It tells you how many times your company sells its total inventory. This number helps you understand sales velocity and how well you manage product purchases. To calculate the inventory turnover ratio, use this formula:

  • Inventory turnover ratio = cost of goods sold / average inventory

Imagine your inventory at the beginning of the month is $100,000. At the end of the month, inventory is $40,000, and cost of goods sold for the month is $350,000. The average inventory is ($100,000 – $40,000) / 2, or $70,000, so inventory turnover is $350,000 / $70,000, or 5.

Turnover varies by industry, so there’s no hard and fast priority for a higher or lower value. Instead, try measuring your inventory turnover ratio regularly to see how your performance changes. That way, if you’re using inventory as collateral, you can use the ratio to show creditors your products are moving quickly.

Analyzing your Business With Solvency Ratios

Solvency ratios, or leverage ratios, measure your company’s ability to sustain operations. They compare your debt, asset, equity, and earnings levels. These ratios tell you if your company can pay its obligations in the long term. When your solvency ratios are strong, it means your business is creditworthy and financially healthy.

Debt-to-Equity Solvency Ratio

The debt-to-equity (D/E) ratio shows the percentage of your financing that comes from creditors and investors. A higher D/E ratio indicates you’re getting more financing from lenders, such as bank loans, instead of investor financing. The formula is the following:

  • D/E = total liabilities / total equity

Imagine your company has $400,000 in total liabilities and $200,000 in equity. The D/E ratio is $400,000 / $200,000, or 2. This means you have $2 of debt financing for every $1 in equity financing, which can be a rather dangerous position. Generally, you want a lower D/E ratio.

Equity Solvency Ratio

The equity solvency ratio shows how much of your business’ assets come from shareholder financing rather than debt. In other words, this ratio tells you the percentage of your company, your investors own. To calculate this ratio, use the following formula:

  • Equity ratio = total equity / total assets

If your company has $500,000 in total equity and $600,000 in total assets, the equity ratio is $500,000 / $600,000, or 83.3%. This means you’re using debt to fund approximately 17% of your company, which is a strong position.

Debt Solvency Ratio

The debt ratio measures how you’re using debt to fund your company’s assets. It tells you about your company’s financial leverage. As such, it’s always better to have a lower debt ratio. To calculate this ratio, use this formula:

  • Debt ratio = total liabilities / total assets

If your company has $800,000 in assets and $400,000 in total liabilities, your debt ratio is $400,000 / $800,000, or 50%. Depending on your industry, this might be rather high.

Times Interest Earned Solvency Ratio

The times interest earned ratio, or the interest coverage ratio, measures the proportionate amount of income you can use to cover the interest expense on your company’s liabilities. It tells you about your company’s ability to service its debt. In this case, higher is always better. Any value less than 1 means your company can’t pay its bills. The formula is:

  • Times interest earned = EBIT / interest expense

For example, if your business has an EBIT of $100,000 and an interest expense of $25,000, the ratio is $100,000 / $25,000, or 4. This means your business earns four times its debt service—a strong position.

These accounting ratios give you a clear picture of how your company stands, both in terms of finances and operations. Great accounting software helps you track all the information you need for each calculation — that way, you can include the ratios in every financial report. 5.6 million customers use QuickBooks. Join them today to help your business thrive.

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