Understanding financial ratios for your small business is a key ingredient in the recipe of your company’s success.
Among other things, ratios can be used to interpret numbers into useful information that can be used to improve your decision making process. Financial ratios help make sense of your accounting information. Ratios also show you what aspects of your business are efficient (and what’s not working) by comparing figures. They help you identify your gains and weaknesses. By looking at trends in your strengths and shortcomings, you can improve business operations.
As a small business owner, you work hard to make your company successful. When problems come up, you face them head-on to push your business forward. Simply writing down your transactions could make you miss Key information about your financial health. You need financial ratios to measure your momentum; you need to be able to interpret ratios.
It does not always have to be fully the function of an accountant to interpret the financial ratios, it will be of great benefit to you if you learn how to interpret them even if you did not calculate them, and they will be useful to your day to day running of the business.
Large companies use a lot of defined financial ratios to analyze the health of the organization. But as a small business you do not have to use all of them.
Here are some of the important ratios that will be of use and are important to your small business.
Profitability ratios
Profit is important to the business, this is one of the main reasons for-profit businesses are set up. You can tell a lot about your profit issues from your profitability ratios.
There are a number of ratios you can use to assess and find answers relating to the profit issues of your business but as small business not all ratios will be used by your company. The ones of great use to you will be the following:
- Gross profit margin: This shows how much money you make from selling your products or services after subtracting acquisition costs, expressed as a percentage.
- Operating profit margin: This is the profit earned from normal business operations, excluding investments, interest and taxes. It is also known as earnings before interest and tax (EBIT), expressed as a percentage. It shows that how much money you’re making from your core business activities.
- Return on Assets (ROA): This ratio shows how well management used the company’s assets to generate profit.
- Return on Capital Employed (ROCE): This measures a company’s profitability and the efficiency with which its capital is employed in the business.
- Return on Equity (ROE): This ratio shows how much profit the company generated using the money invested by shareholders.
Growth ratios
A business has to grow in order to survive. Growth will ensure that the business goes on for the foreseeable future.
The important ratios that can help you with your company’s growth are:
- Inventory turnover: This shows how frequently you convert inventory into sales. It shows how much product is sold and how efficiently you manage inventory.
Other ratios of importance to measuring the growth of your business include the employee to sales ratio, the debt to equity ratio, the working capital ratio, and the Lead to conversion ratio.
Liquidity Ratio
Liquidity ratios are very important because the highlight when a business is about to fall into financial difficulties.
Ratios that can help you here, include:
- Current ratio: a current ratio shows your present financial strength. It represents how many times bigger your current assets are compared to your current liabilities.
- Quick ratio: Sometimes also known as the acid test ratio, this is one of the important liquidity ratios, it shows us how well a company can meet its current liabilities using its most liquid assets. In easier terms it basically gives you a quick look at your funds position and ability to make upcoming payments and purchases.
There are quite a number of ratios that you can use for your business and though you won’t need to use all of them, using the important ones to compare financial numbers will help your business recognize successes and solve problems. The numbers in your accounting books tell a story. They show where you’ve been and suggest where you’re headed.
Learning how to calculate, track and interpret your own financial ratios is a vital part of being a responsible and ultimately successful business owner. So don’t lay back, learn yourself how to understand and interpret your financial ratios or engage a financial expert to assist you.
