A business can survive and thrive in the long run with a strong financial base. A solid financial foundation allows businesses to expand and experiment in the long run. With a weak financial structure, businesses cannot survive and diversify their product line. A well-built financial structure is essential, especially for small businesses that focus on building a brand name and staying consistent.
Small businesses often feel overwhelmed by the numbers in the financial statements. The financial statements contain a lot of information that can be used to judge the health of a business. Financial ratios use the information derived from the financial statements to measure a company’s financial health. Financial ratio analysis enables businesses to get insights into a particular company.
Financial ratios help turn the raw data into productive information, ensuring effective business management. Financial ratios are calculated from the information derived from the cash flow statement, balance sheet, and profit and loss statement.
Why is financial ratio analysis important?
Financial ratio analysis provides valuable insights into liquidity, profitability, efficiency, etc. These ratios enable businesses to evaluate their performances over a period of time. This facilitates comparison with the competitors of the same industry or area. In addition, financial ratios can also be used by investors to determine the health of a business. A publicly-traded company can monitor the key financial ratios to know how the investors view their business. With a proper understanding of the factors that affect the ratios, appropriate steps can be taken to produce more results.
A business can calculate, measure, and monitor several financial ratios. Though there are a lot of ratios to track, a small business should stick to certain important ones. Let us get an in-depth understanding of the key financial ratios for small businesses:
Key financial ratios for small businesses
- Net profit margin– The net profit margin ratio is used to determine the ability of a business to produce profits and to consider various scenarios. In simpler terms, net profit margin or profit margin is a financial ratio used to calculate the percentage of profit a business produces from its overall revenue. It is calculated after deducting all the operating expenses, interests, and taxes. Net profit margin is a strong indicator of a company’s overall success. Investors often use it to know how a company manages its costs and converts revenues into profits. The formula for the same is as follows:
Net profit margin = Total revenue – Total expenses / Total revenue
A high net profit margin indicates efficient management, fewer expenses, and strong pricing strategies. On the other hand, a low net profit margin ratio indicates inefficient management, high costs, and weak pricing strategies.
- Cash flow to debt– This ratio measures a business’s cash flow from its operations with its total debt. This ratio can be a red flag predictor for small businesses dealing with cash flow problems. Most small businesses fail due to cash flow issues since much of their cash is spent on debt repayment. In simpler terms, it tells how much money a business had made in an accounting period from operating a business instead of receiving money from loans or investments. In financial ratio analysis, the cash flow to debt ratio can be considered before buying stock in a company to overview its operating cash flow. The formula to calculate the cash flow to debt ratio is:
Cash flow to debt = Operating cash flow / Total debt
A ratio of 1 or more is considered best, indicating a firm is generating sufficient cash flow. On the other hand, a ratio less than one highlights a firm doesn’t have much cash flow and liquidity to meet its debts.
- Quick ratio– This ratio, also known as the acid test ratio, evaluates whether a business has sufficient liquid assets that can be converted into cash to settle its bills. It is also known as the liquidity ratio since it deals with liquid assets that can easily be converted into cash. The liquid assets include cash, marketable securities, and accounts receivable but not inventory and prepaid expenses. In financial ratio analysis, the quick ratio serves as a barometer to judge the ability of a company to meet its current obligations. Well-defined liquidity or quick ratio is a sign of competence and sound business performance, which leads to sustainable growth. The formula for quick ratio goes like this:
Quick ratio = {Current assets – Inventory- Prepaid expenses} / Current liabilities
A ratio above 1 indicates that the company possesses sufficient cash or cash equivalents to cover its short-term financial obligations. On the other hand, a ratio below 1 indicates the inability of a company to meet its short-term liabilities.
- Accounts receivable turnover- When small businesses conduct a financial ratio analysis, the accounts receivable turnover ratio cannot be missed. The accounts receivable turnover ratio quantifies how well a business manages the credit extended to the customers. It keeps a close check on how small businesses handle their collections. Small businesses need enough cash flow to survive and diversify their business, and the account receivable turnover ratio monitors the same. The AR turnover ratio shows how long it takes for the customers to pay, which reveals a business’s financial stability. The formula for AR turnover ratio goes like this:
Accounts receivable turnover ratio = Net annual credit sales / Average accounts receivables
A higher number is better since it indicates that your customers are paying on time. Also, a higher number points toward a better cash flow system, a stronger balance sheet or income statement, and even stronger business creditworthiness.
- Inventory turnover ratio– An efficiency ratio helps measure how well a company can manage its inventory. It is the number of times a business has sold or replenished its inventory over time. The ratio, also known as the stock turnover ratio, shows how efficiently a company’s inventory is managed. This ratio should only be used to compare the industries operating in the same field or area because the ratio highly depends upon the industry standards. A high inventory turnover ratio in financial ratio analysis reduces storage and other holding costs. On the other hand, a low turnover ratio implies poor inventory management or poor sales of the company. The formula goes like this:
Inventory turnover ratio = Cost of goods sold / Average inventory
The inventory turnover ratio is a key indicator of a business’s profitability and operational efficiency. A better understanding of the ratio allows businesses to increase their profitability and make better business decisions.
Bottom line
Financial ratio analysis helps businesses identify their strengths, weaknesses, and areas of opportunity. A single financial ratio is used in combination with others to achieve maximum results. The business owners, external parties, or investors can pick up the best stocks for their portfolios by considering financial ratio analysis.
The whole process of calculating financial ratios is burdensome and time-consuming. In addition to this, it demands expertise and experience. Therefore, we at Whiz Consulting can provide a helping hand to ensure an effective financial ratio analysis. Our experts are employed with the latest financial ratio analysis software, making the process much easier. With the right expertise and knowledge, your business can experience newer heights of success.
