Informed decision-making is one of the keys to managing a small business so that it stays on the path to growth and profitability. And one of the best ways to make informed decisions is to identify trends in your finances that reveal your business’ strengths and weaknesses. Ratio analysis is a tool you can use to identify those trends.
What Is Ratio Analysis?
These financial measurements will provide you with information about your company as you compare the current accounting period to previous ones. As you make these comparisons, you should look for trends. For example, are the ratios increasing or decreasing, and what does that mean for your business? By setting up a spreadsheet, you can create a visual look at the ratios you are comparing. You can perform a ratio analysis for just about any financial area in your business, but here are four that every business owner should look at.
Your current ratio, also known as a working capital ratio, is a good indication of whether or not your business will be able to pay its debts over the next year, and it will guide you when you are considering taking on more debt. It is also a good indicator of whether a business is making good use of its cash. A financially healthy company will typically have a ratio between 1.5 and 3, although it varies from industry to industry. If your ratio is below 1, you may have trouble meeting your short-term financial obligations, and if it’s too high, you might not be making the best use of your financial assets. To arrive at this ratio, use this formula:
Current ratio = current assets / current liabilities
If your current assets equal $30,000, and you have liabilities of $15,000, your current ratio is 2.
Inventory Turnover Ratio
If you carry inventory, you need to know how quickly it is turning over compared to past years to be able to gauge how well you’re managing it. A lower inventory turnover ratio means you’re not efficiently managing your inventory and may be overstocking. A very high turnover ratio may put you at risk for an inventory shortage that could result in lost sales. To determine this ratio, first determine your average inventory by adding the value of your inventory at the beginning and the end of the period, and dividing it by 2. Then, use this formula:
Inventory turns = cost of goods sold / average inventory
If a company spends $10,000 to sell its goods, and its average inventory is $5,000, then it turns over inventory twice a year. Companies that sell perishable goods should have a higher inventory ratio, while businesses that sell durable goods have lower ratios.
Profit Margin Ratio
Business owners need to compare their current profit margins with historic numbers to ensure their business stays on track and remains profitable. A high profit margin is a good indicator that your business has sufficient cash flow to meet its obligations and can finance any intended growth, but a low one indicates you may need to cut expenses or make some other adjustment, such as a price increase. To figure out this ratio, use this formula:
Profit margin = net income / net sales
If a company sold $100,000 in goods and made $10,000 in income, its profit margin would be 10 percent.
To determine the long-term financial health of your company, you can determine your debt-to-equity ratio. This number shows how your company stands in relation to its long-term financial obligations. By comparing trends, you will see whether your debt load is rising, which could possibly mean that your business can’t generate enough income to pay its obligations. The maximum acceptable rate for small businesses is typically less than 2, although this ratio is industry specific. Here is the formula:
Debt-to-equity ratio = total debt / total equity
If your company carries $15,000 in debt and has $10,000 in equity, your debt-to-equity ratio is 1.5.
By determining these ratios for your business, you will be better able to spot trends, and can use that information to make informed decisions to minimize financial risk and spur growth.