Are you looking to build your company? Great financial management can help. When you know what’s going on with your company’s finances, you can make better decisions, keep projects profitable, and grow the company at a manageable pace. One way to understand your business’s finances is ratio analysis. This method helps you track financial trends that can affect your company, now and in the future.
What Is Ratio Analysis?
When you’re looking at your financial statements, you’re faced with a wall of numbers. Ratio analysis helps you make sense of the data. This method uses ratios to help you analyze common statements, including balance sheets, cash flow statements, and income statements. You can use ratios to track a variety of factors, including:
- Debt: The money your company owes
- Profit margin: The percentage of revenue you have left after you deduct your expenses
- Inventory turnover: How many times you have sold your product inventory and replaced it with new products
During a ratio analysis, you track specific ratios over time to figure out if your company is improving or declining. You can also use ratios to find opportunities for improvement. That way, you can spend your money and time where they’re needed the most.
Income and Profitability Ratios
Have you ever wondered if you’re using your company’s resources efficiently? Income and profitability ratios can help. These ratios tell you how optimally your company makes a profit, even after you pay operating expenses and other costs. In most cases, you want these ratios to increase over time. By tracking income and profitability ratios, you can figure out which products are most successful, which makes it easier to tailor your offerings to meet customer demand. Some common income and profitability ratios include:
Gross Margin Ratio
When you sell a product, you need to spend money to buy and store inventory. Do you want to better understand how those costs eat into your profits? The gross margin ratio can tell you. This ratio tells you what percentage of your revenue goes toward the cost of selling goods and what percentage your company takes as a profit. To calculate the gross margin ratio, divide your gross profit, or the amount you have left after you subtract expenses from your revenue, by your sales revenue.
Imagine you spend $100,000 on inventory. You then sell that inventory for $600,000. To calculate your gross margin, you would subtract $100,000 from $600,000 and then divide the result by $600,000 to get 78%. This means you get to keep 78% of your revenue to pay down debts, hire administrative staff, and reinvest in your business.
If your gross profit ratio is low, you can look for ways to increase it. You might negotiate a discount from your inventory supplier to lower expenses, for example, or you could raise your prices to increase profits.
Profit Margin Ratio
Do you have plans to ramp up sales and increase your revenue? The profit margin ratio can tell you if higher sales actually bring you the higher profits you’re looking for. This ratio tells you how much profit you make for every dollar of revenue you bring in. In other words, it tells you how much profit you have left after you pay all of your expenses. Unlike the gross margin ratio, this ratio considers all expenses, not just the cost of goods sold (COGS). To calculate this ratio, divide your net after-tax income by your net sales.
The profit margin ratio tells you how profitable your company is at different sales levels. Imagine that one year you make $100,000 in net income after taxes, and your net sales were $500,000. Your profit margin ratio is $100,000 divided by $500,000, or 20%. The next year, you bring in a net sales of $800,000, but due to increased costs, your net income after taxes rises to just $150,000. That year, your profitability margin is $150,000 divided by $800,000, or 18.75%. So, even though your revenue was considerably higher, your profit margin dropped. Having this information helps you look for factors you can improve on, such as reducing overhead costs.
For small businesses, profit margins are crucial. By measuring your profit margin ratio, you can find the ideal balance of revenue and costs to maximize profit.
Complementary Gross Profit on Net Sales Ratio
Do you notice that your sales are booming, but your bottom line doesn’t seem to be growing at the same time? The complementary gross profit on net sales ratio can help you figure out if you’re making enough of a profit on each product you sell. To calculate this ratio, divide your net sales minus the COGS by your net sales. This ratio shows you how much profit you make on each unit you sell. This number helps you figure out how many items you need to sell to cover your costs, and it can help you set sales targets throughout the year.
Operating Margin Ratio
If you’re looking for investors or planning to borrow money, you can expect to provide them with your operating margin, which is your operating income divided by your net sales. This number tells you how much of your revenue comes directly from operations.
Why do investors care? A high operating margin ratio means your company is making enough money from your operations to cover your costs, which usually means that it’s stable and well-managed. That’s a good sign, and it might make investors and lenders more likely to pour cash into your business.
Net Profit on Net Sales Ratio (Net Profit Ratio)
As a business owner, you need to know the overall profitability of your business once you factor in taxes. That’s where the net profit ratio comes in. To calculate this ratio, divide your after-tax earnings by your net sales. If you’re bringing in $60,000 in earnings after tax, and your net sales are $150,000, your net profit ratio is $60,000 divided by $150,000, or 40%. That means that for every dollar in revenue, you get to keep 40 cents in profit after you pay taxes.
To see how your business is performing, you can track your net profit ratio over time. When your net profit ratio increases, it means you’re managing the company effectively and using your assets efficiently, and as a result, you’re increasing profits. You can also compare your net profit ratio to industry averages to find out how well your company is doing compared to other businesses.
Working Capital and Liquidity Ratios
Working capital and liquidity ratios give you a realistic look at your business’s assets and how well you’re able to use those assets to make a profit and pay off debts. To calculate these ratios, you need your company’s cash flow statement and balance sheet.
Net Working Capital Ratio (Current Ratio)
When you run a business, you rack up a variety of liabilities, ranging from mortgage payments to utility bills. Is your company able to cover all of your short-term bills? If you’re not sure, you might want to check your current ratio. This ratio compares your current assets, such as cash and inventory, to your current liabilities, such as wages and vendor payments. To calculate the ratio, divide your current assets by your current liabilities.
If your current assets are worth $100,000 and your current liabilities total $75,000, your current ratio is 1.33. In other words, you can comfortably pay your bills. If your ratio is less than 1, it means you might not be able to cover your short-term liabilities.
It’s also helpful to compare your current ratio to the average for your industry. If your ratio is considerably higher, it means you might not be using your resources efficiently. You might be incurring too much debt from investing in growth opportunities, for example, and may want to consider scaling back so you have more cash on hand.
Working Capital Turnover Ratio
To grow your business, you need to use your working capital effectively to bring in more money. But how do you know how well you’re doing? The working capital turnover ratio can tell you. Calculate this ratio by dividing net sales by net working capital.
If your working capital ratio is 1:5, it means you’re generating $5 for every $1 you invest in your operations. If your ratio is high compared to other companies in the industry, it means you’re using your working capital effectively to make more money.
If your ratio is low, it means you’re not using your capital as effectively as you could. You might be spending too much money on inventory that’s not selling well, for example. In that case, you could improve your ratio by getting rid of slow-moving products and investing your working capital in more popular products. That way, you can bring in more revenue while spending the same amount of capital.
Quick Ratio (Acid Test)
The acid test is another way to determine if your company has enough money to pay its immediate debts. This ratio is similar to the current ratio, with one big difference: it does not include your inventory. Instead, the ratio uses your liquid assets — items you can convert to cash quickly to pay off your short-term debts. Why does that matter? It gives you a more accurate idea of how well you can cover your liabilities without taking the time to sell off inventory.
To calculate this ratio, add your current cash on hand, your marketable securities, and your net accounts receivable. Then, divide that sum by your current liabilities to get your quick ratio. Usually, you’re looking for a quick ratio of 1 or higher.
Imagine your current assets, including inventory, are worth $100,000, and your current liabilities are $75,000. Your current ratio is 1.33, which seems to indicate you’re in a healthy financial position. However, when you subtract inventory, your assets come to $50,000. You would then divide $50,000 by $75,000 to get a quick ratio of 66.7%, which is less ideal. That means you need to move inventory to pay your bills, and if sales start to slow down, you could start to feel the pinch.
When your quick ratio is low, you can take action by increasing sales and collecting client invoices faster. You might also consider paying bills on their due dates rather than weeks in advance. If your quick ratio is low compared to your current ratio, you might consider reducing inventory costs.
Current Debt to Net Worth Ratio
Are you looking for a way to measure your company’s overall financial health? The current debt to net worth can give you a quick snapshot. Figure out this ratio by dividing your current liabilities by your tangible net worth, or your net worth including both physical assets and intangible assets like patents and intellectual property. The result shows you how much of your business funding is comprised of debt. When you’re carrying less debt, you’re more attractive to investors. You might also find it easier to get a business loan when you want to expand.
Larger companies can usually manage a 75% ratio in this area. If you’re running a smaller company, and your ratio is more than 60%, you might consider finding ways to reduce debt, such as selling off slow-moving products.
Absolute Liquidity Ratio
Does your company have loans? If so, it’s a good idea to measure your liquidity, or your ability to convert your company’s assets into cash. The more liquid your assets are, the easier it is to pay back your creditors. If you’re not liquid, you might need to sell your long-term assets to cover your debt payments, which can affect your operations.
The absolute liquidity ratio gives you an idea of your position in this regard. To calculate it, divide your cash and marketable securities by your current liabilities. This ratio tells you how many times you could pay your current debts if you turned your assets into cash. If you have liquid assets of $25,000 and current liabilities of $30,000, your absolute liquidity ratio is 0.83.
In general, you want this ratio to be near 0.5. A ratio that is considerably lower means you might have trouble paying debts. In that case, you could shorten client payment deadlines, cut expenses, or find ways to boost your sales numbers.
Funded Debt to Net Working Capital Ratio
If you’re like many business owners, you might need to take on debt and pay interest as you grow your company. This is called funded debt. In most cases, you don’t want your long-term debt to be higher than your working capital.
To find out where your company stands, divide your long-term debt by your net working capital, which is the difference between your current assets and liabilities. If you have $80,000 in funded debt and $300,000 in working capital, your ratio is 0.267. That means you’re easily able to pay down your debt with your working capital.
In general, you’re looking for a ratio that’s less than 1. If the ratio is higher than 1, it means you might struggle to pay your debts down the road and need to take on additional debt. When that’s the case, it’s important to reduce your long-term liabilities.
When you take the time to calculate and analyze these ratios, you can get a clear picture of your company’s finances. The ratios tell you where your company is excelling and where it needs work. That way, you can leave well-tended portions alone and focus your energy on areas that need improvement. Tracking trends with ratio analysis can help you find opportunities for growth, which can springboard your business to bigger, better things. While you’re making changes, improve your cash flow with invoices, payments, and expense tracking. See how much cash you have on hand with QuickBooks.