The success of your small business hinges on you staying on top of all your company finances. This helps you make better decisions that foster business growth at a pace you can handle and ensure profitability for each project. Knowing where your business is strong and where it needs some work also shows you where to allocate resources and direct attention. One of the best ways to understand every aspect of your business’s big picture is through ratio analysis, which helps you track financial trends that can affect your company in both the short- and long-term.
What Is Ratio Analysis?
One way of looking at ratio analysis is as a business’s batting average. More precisely, ratio analysis is basically a measured study of information found in your business’s financial statements. This process uses spreadsheets to examine numerous key documents, including balance sheets, cash flow statements and income statements, then calculates ratios of one item compared to another item. By performing these calculations, you can evaluate financial and operating performance by liquidity, solvency, profitability and efficiency. This helps you look at trends of short-term and long-term time periods to determine where you stand to gain and lose by staying on your current course, as these ratios not only show previous trends but also point to future indicators of success or failure.
Some Types of Ratios Analysed
Typical ratios analysed by business owners looking to track financial trends include the current ratio, profit margin ratio, debt-to-equity ratio and inventory turnover ratio. Other important ratios to consider involve income, working capital, leverage and coverage.
Take a look at each of these factors over time, you can track where your company has been, where it’s on track to go and where it could go if certain changes were implemented. Keep in mind that factors may have changed from one period to another. Due to this, you should consider any changes in accounting policies that occurred during the time frames you’re studying.
Income and Profitability Ratios
Income and profitability ratios are determined by your company’s income statements. Among these, the gross margin ratio compares your sales revenue with gross profits to determine the percentage you can reinvest after you sell those goods. To calculate the profit margin ration, divide net after-tax income by net sales, this tells you the per-sale profit after you deduct all other expenses. The complementary gross profit on net sales ratio shows you how much profit you make on each unit you sell by dividing net sales minus cost of goods sold by your net sales.
You can calculate your operating margin ratio by dividing operating income by net sales. This shows you revenue after variable cost expenses, including materials and wages. In terms of profitability, the net profit on net sales ratio reveals how much you actually earn by dividing earnings after tax by net sales. When tracked over time, these types of ratios help you sort through product winners and losers to better tailor your offerings to your customer base.
Working Capital and Liquidity Ratios
Working capital and liquidity ratios give you a realistic look at your business’s funding by studying your company’s cash flow statements and balance sheets. By comparing your assets to your liabilities, the net working capital ratio, or current ratio, helps you ensure you have enough money to cover operating expenses that you can’t avoid, such as wages and raw materials, manage short-term debt payments, and determine if you’re making wise use of your funds.
The working capital turnover ratio reveals if your company has too many slow-moving assets, which can require you to reinvest in other sectors to support fixed investments. You can calculate this ratio by dividing net sales by net working capital. From a liquidity standpoint, the quick ratio, or the acid test, shows you if you can convert current assets to cash to cover unexpected surprises. You can calculate this by adding your current cash on hand, marketable securities, and net accounts receivable, then dividing the sum by your current liabilities.
The current debt to net worth ratio divides your current liabilities by your tangible net worth, which shows how much debt goes into your business funding. While larger companies can hold up with a 75% ratio here, smaller companies with more than a 60% ratio should consider options that reduce debt, such as selling slow-moving investments. On the flip side, the absolute liquidity ratio determines how easily you could liquidate all business assets by dividing your cash and marketable securities by your current liabilities.
Another important comparison is the funded debt to net working capital ratio. Determine this by dividing your business’s long-term debt by your net working capital. This ratio helps prevent your long-term liabilities from eventually exceeding your net working capital, which could lead to your business going deeper into debt.
While calculating all these different ratios may seem time consuming, this process can help you build a better business. Find where you excel and where you need work, this way you can let well-tended portions go and grow while you focus time and attention on areas where you require improvement. Tracking trends using ratio analysis can point to areas for growth, which can springboard your business to bigger, better things.