Along with running and analyzing financial statements, a small business will become more successful if it consistently evaluates the profitability of its performance. One way of evaluating profitability is by calculating financial ratios. There are many financial ratios that exist and selecting the appropriate ones is a task in itself. First you must determine what you want to measure. One can measure profitability and income, liquidity and leverage, cash flow, working capital etc. The ratios that are often used by small business owners are current ratio, quick ratio, gross profit margin and net profit margin, and debt to equity ratios.
Liquidity Ratios
Calculating a current ratio and a quick ratio will help with measuring the liquidity of your business. In another words, it will help you determine if you can meet your short term obligations. The current ratio measures if a company can cover its current liabilities by paying down its current assets. It is calculated by taking current assets and dividing by current liabilities. A current ratio that is less than 1 means the company’s assets are not completely covering its liabilities. A company with a current ratio around 2 would be ideal signifying that the company’s assets are twice that of its liabilities.
A quick ratio is similar to the current ratio except that with the quick ratio, the inventory is deducted from current assets. The quick ratio shows the company’s ability to meet its short term obligations without having to sell inventory.
Profitability Ratios
The gross profit margin and net profit margin are profitability ratios that show how well a company can generate profits. The gross profit margin is simply the company’s gross profit divided by sales. It represents the revenue the company makes against the direct cost of the company’s product or service. Therefore, it’s an excellent way to observe if it’s costing too much to make your product.
The net profit margin percentage is calculated by taking net profit and dividing by sales. This would show how much profit is generated for every sale dollar after accounting for expenses. The target % for the both margins will depend on your industry. Once you determine what the target is for your industry you can see how well your company compares to it.
Leverage Ratios
Leverage ratios measure how much total debt is on the balance sheet. A common leverage ratio among small businesses is the debt to equity ratio. It is the direct relationship between the company’s shareholders equity and the debt that it is used to finance a company’s assets. It’s calculated by taking the total short term and long term debt divided by the total equity in the company. A very high debt ratio would show that the company is aggressively financing its assets. If the increased financing doesn’t lead to increased revenue streams (which in the end benefits the shareholder) this could be a significant risk to the company. A low debt ratio means the company is managing its debt effectively while producing enough revenue for shareholders. The target ratio would depend on the type of industry your company is in.
Comparing your ratios to past ratios, competitors or industry standards would provide much insight on how your business is doing. When you are comparing the ratios, make sure the time periods for when you calculate the ratios are the same. For instance if you care calculating a ratio as of fiscal year end you will probably want to compare that same ratio to another fiscal year end.
By: Andrea Tupper
