Summer is officially upon us, which also means that it’s the midyear point of 2014. With Q3 getting underway, it’s time to check in on the health of your small business. Financial ratios can be powerful tools to help you determine how your business is performing. Here is a breakdown of the key financial ratios in each category, how to calculate them and what they tell you about your business. While some ratios are universal, others will be specific to your industry or company, but either way, knowing which are important in monitoring the pulse of your business is crucial, as trends can tell you much more than individual measurements.
The key financial ratios pertinent to virtually any business fall into four broad categories: liquidity, efficiency, risk and profitability.
• Liquidity: current ratio (current assets/current liabilities). This ratio should be checked at least once a month. It tells you how much you have in cash, or will turn into cash in the next 12 months, for every dollar that you have coming due in the same period. Typically a ratio of 1 to 1.2 is considered healthy. However, if that ratio drops below 1, you have a problem – not enough liquidity to meet your upcoming payables. But if it inches too high, it’s possible that you’re not investing your excess cash correctly, or your inventory is creeping up on you. Components of the current ratio that are worth examining include days in accounts receivable (how long on average it takes you to get paid, calculated as average accounts receivable/sales times 360) and days in inventory (average inventory/cost of goods sold times 360), which are technically measures of efficiency.
• Efficiency: return on assets (net income/total assets). This ratio indicates how efficiently you’re converting your investments in real estate, equipment and other assets into revenue. Take two competitors in the same industry, making the same return of $1 million each. But Company A did so with assets of $4 million, for a 25 percent return on assets, while Company B poured in $5 million, for a return on assets of 20 percent. Here, too, the numbers may not tell the whole story. What if, for instance, the additional $1 million that Company B paid out was a strategic investment in new technology or markets that would give it a significant competitive advantage in the near future? Other measures of efficiency indicate how quickly you move through the cash flow cycle. These include accounts receivable turnover (net sales/average accounts receivable), inventory turnover (cost of goods sold/average inventory) and accounts payable turnover (cost of goods sold/average accounts payable). The higher the numbers, the more quickly you are receiving cash for your outlays.
• Risk: debt to equity (total liabilities/shareholder equity). Lenders often look at this financial ratio to determine how well-capitalized your company is. The higher the ratio, the more dependent you are on future profits to pay for your debt – in other words, the more you’re betting on the future. A smaller number means you are funding your operation off profits already in the bank. Again, the number means little without context. While lower is generally better, it may be high if, for instance, you’ve just drawn from a line of credit to purchase inventory for a contract project yet to generate receivables. Another useful ratio in evaluating debt-related risk is the debt coverage ratio (net profit plus noncash expenses such as depreciation/total liabilities), which indicates how much of your cash profits are available to repay your debt. • Profitability. There’s profit, of course, and then there’s profit. Gross profit (gross sales minus cost of goods sold) may tell you what you make off each sale, but net profit (gross sales minus total expenses) is what you literally take to the bank. The difference is overhead, which can also be expressed as a ratio: selling, general and administrative expenses/gross sales. This is something you want to keep steady or lower over time. If you are finding yourself bogged down in a sea of numbers, a concise dashboard of critical financial ratios can help you cut through the clutter and see where your business is headed. For more small business insights and information, visit www.Regions.com/businessinsights.
Scott Jones is the Dallas/Fort Worth president for Regions Bank.