The 12 Best Financial Ratios for a Small Business

The Importance of Tracking Financial Ratios for Small Business Owners

As a small business owner, measuring financial ratios is essential for understanding the financial health of your business. Financial ratios are measures of the relationship between two or more components on your company’s financial statements, which give you a quick and straightforward way to track performance, benchmark against those within an industry, spot trouble and proactively put solutions in place.

Measuring financial ratios is important for small business owners for several reasons. First, financial ratios help you compare your business with competitors and more generally with those within your given industry. This enables you to benchmark your performance and target areas for improvement. Second, they help you see problematic areas and put measures in place to prevent or ease potential issues. Third, if your business is seeking outside funding from a bank or an investor, financial ratios provide those stakeholders with the information needed to see if the business will be able to pay the money back and produce a strong return on investment.

The Most Important Financial Ratios

There are dozens of financial ratios you can track, but the most important financial ratios fall into one of four broad categories: liquidity, leverage, profitability, and asset management. We’ll look at 10 ratios across these four categories and provide a detailed walkthrough for each.

Liquidity Ratios

Liquidity is a measure of your business’s ability to cover its short-term obligations, such as accounts payable, accrued expenses, and short-term debt. When a company has liquidity troubles, it may have trouble paying employees and suppliers and covering other daily operating expenses, leading to big problems. Liquidity ratios typically compare the company’s current assets (cash, inventory, and receivables) with current liabilities.

1. Current Ratio

This ratio estimates your ability to pay short-term obligations—liabilities and debts due within one year. Ideally, your current ratio will be greater than one, meaning you can settle every dollar owed for payables, accrued expenses, and short-term debts with your existing current assets.

Current Ratio = Current Assets / Current Liabilities

A current ratio of less than 1 suggests that you may have trouble paying off your short-term obligations. A ratio of 1.5 or higher is generally considered good, indicating that your business can comfortably cover its short-term obligations.

2. Quick Ratio

This ratio looks at only the company’s most liquid assets (cash, marketable securities, and accounts receivables) rather than all current assets. A quick ratio above 1 means your business has enough liquid assets to cover short-term obligations and maintain your operations.

Quick Ratio = (Current Assets – Inventory – Prepaid expenses) / Current Liabilities

A quick ratio of less than one suggests that you may have trouble paying off your short-term obligations. A ratio of 1 or higher is generally considered good, indicating that your business can comfortably cover its short-term obligations without having to sell off its inventory.

3. Working Capital

Working capital is the money available to a business for its day-to-day operations. The working capital ratio measures a company’s ability to meet its short-term financial obligations using its current assets. It indicates whether a company has enough cash or other liquid assets to cover its short-term liabilities, such as accounts payable, accrued expenses, and short-term debt.

Working Capital Ratio = Current Assets / Current Liabilities

A ratio of 1 or greater indicates that a company has sufficient current assets to pay off its current liabilities. However, a ratio that is too high may mean that a company is not using its current assets efficiently, which could lead to missed opportunities for growth or investment. On the other hand, a ratio that is too low may indicate that a company is at risk of running out of cash and not being able to meet its short-term financial obligations.

As a small business owner, keeping a close eye on your working capital is critical to ensure your company’s financial health and ability to cover short-term obligations. Working capital gives you the flexibility to handle day-to-day cash flow needs, deal with unexpected expenses, and take advantage of growth opportunities requiring quick access to cash. Rather than tracking working capital manually in spreadsheets, using accounting software that automatically calculates key metrics like your current ratio and quick ratio. Automated monitoring saves you time, gives you real-time visibility into your liquidity levels, and allows you to generate reports or forecasts quickly. More importantly, the software provides warnings when your working capital dips below target thresholds. This gives you time to take corrective actions – whether adjusting purchasing plans, collecting receivables faster, or securing working capital financing if needed.

Leverage Ratios

Leverage is the amount of debt your company has in its capital structure, which includes both debt and shareholders’ equity. A company with more debt than average for its industry is considered highly leveraged.

4. Debt to Equity Ratio

Your debt-to-equity ratio compares total debt to total equity to measure the riskiness of the company’s financial structure. Lenders and other creditors closely monitor this metric, as it can provide an early warning sign when companies are taking on too much debt and may have trouble meeting payment obligations.

Debt to Equity Ratio = (Long-Term Debt + Short-Term Debt + Leases) / Shareholders’ Equity

A good debt-to-equity ratio varies by industry. A ratio of around 2 or 2.5 is generally considered good for most companies. That means that for every dollar shareholders invest in the company, about 66 cents comes from debt while the other 33 cents come from equity.

However, companies with consistent cash flows might be able to sustain a higher ratio without running into problems. If the debt-to-equity ratio is too high, it may indicate that the company is relying too heavily on debt financing, which can increase financial risk and limit the company’s future borrowing capacity. On the other hand, a very low debt-to-equity ratio may indicate that the company is not taking advantage of leverage to maximize returns for shareholders. As with other ratios, it’s important to compare the debt-to-equity ratio against industry benchmarks to evaluate whether it is good, bad, or neutral for the company’s financial health.

5. Debt to total assets

Your debt to total assets ratio tells you the percentage of your company’s assets financed by creditors.

Debt to Total Assets = Total Debt / Total Assets

A high debt-to-total assets ratio means that a significant portion of the company’s assets are financed by debt, which can be risky for investors. It shows that the company is heavily reliant on borrowing to finance its operations and growth.

Most investors prefer to put their money into companies with a debt-to-total assets ratio below 1. This indicates that the company has more assets than liabilities and could pay off its debts by selling assets if needed.

However, a high debt-to-total assets ratio is not necessarily a bad thing. It depends on the industry and the nature of the company’s operations. For example, capital-intensive industries such as manufacturing and infrastructure tend to have higher debt-to-total assets ratios because they require significant investments in assets such as plants and equipment.

When interpreting this ratio, it’s important to look at the trend over time and compare it to industry benchmarks to understand how the company’s financing strategy compares to its peers. A company with a high debt-to-total assets ratio that is steadily increasing may be taking on too much debt and could be at risk of defaulting on its loans. On the other hand, a company with a high ratio that is decreasing may be paying down its debt and improving its financial position.

Profitability ratios

Profitability ratios evaluate your ability to generate income (profit) and create value for shareholders.

6. Profit Margin

Your gross profit margin measures the amount of profit you make on each dollar of sales after deducting the cost of goods sold. This ratio can help you evaluate how effectively you manage your production costs, inventory, and pricing strategy.

Gross Profit Margin = (Revenue – Cost of Goods Sold) / Revenue

The higher your gross profit margin, the better, as it indicates that you have more money left over to cover operating expenses and earn a profit.

7. Net profit margin

Your net profit margin measures how much profit your company generates for each dollar of revenue after deducting all expenses, including taxes and interest. This ratio provides a clear picture of how efficiently you manage your costs and pricing strategy.

Net Profit Margin = Net Income / Revenue

A higher net profit margin is generally better, as it means your company is generating more profit for each dollar of revenue.

8. Return on Assets

Return on assets (ROA) indicates how well your company is performing by comparing your profits to the capital you’ve invested in assets. The higher the ROA, the more efficiently you use your economic resources.

Return on Assets = Net Income / Average Total Assets

While comparing your ROA to other companies in your industry is helpful, it’s more helpful to look at how your return on assets changes over time. If this metric rises from year to year, it generally indicates that you’re squeezing more profits out of each dollar of assets on the balance sheet. However, if your ROA is declining, it could mean you’ve made some bad investments.

9. Return on Equity

Your return on equity (ROE) measures the company’s ability to generate profits from shareholder investments into the business.

Return on Equity = Net Income / Shareholders’ Equity

A good ROE depends on your industry. For example, according to the NYU Stern School of Business, the ROE for electronics companies averages around 44%, while engineering and construction companies average just above 6%.

A high ROE is generally good as it indicates that the company is able to generate profit from shareholder investments. However, a low ROE may indicate that the company is not effectively utilizing shareholder investments or may be taking on too much debt.

Asset and Capital Efficiency Ratios

Asset management ratios analyze how efficiently a company uses its assets to generate sales. The following ratios are normally only used by businesses that carry inventory or sell to customers on credit.

10. Return on capital employed (ROCE) or capital efficiency (%)

ROCE measures the return a company earns on all the capital invested in its operations. This ratio is especially useful when comparing companies in the same industry or sector.

ROCE = Earnings Before Interest and Taxes (EBIT) / Capital Employed

Capital Employed = Total Assets – Current Liabilities

The higher your ROCE, the more efficiently you use your capital to generate profits.

Your sustainable growth rate tells you how much your company can grow without having to borrow additional funds or issue new shares. This ratio can help you evaluate whether your company is generating enough internal funds to sustain growth without relying on external financing.

Sustainable Growth Rate = ROE x (1 – Dividend Payout Ratio)

A higher sustainable growth rate is generally better, as it means your company can grow without having to raise additional capital from investors or lenders.

11. Inventory Turnover

Your inventory turnover ratio measures how efficiently you manage inventory.

Inventory Turnover Ratio = Cost of Goods Sold / Average Inventory

When evaluating your inventory turnover ratio, compare your metric to companies operating in the same industry. A low inventory turnover ratio compared to the industry average can indicate that your sales are poor or you’re carrying too much inventory.

A high inventory turnover ratio indicates that the company is effectively managing its inventory and selling products quickly. However, a low inventory turnover ratio may indicate that the company is struggling to sell products or is holding onto too much inventory.

12. Receivables Turnover

Receivables turnover measures how quickly you collect sales made on credit.

Receivables Turnover = Net Annual Credit Sales / Average Accounts Receivable

Determining whether your receivables turnover ratio is good or bad involves comparing your metrics to your company’s credit policies and payment terms. For example, if your credit terms allow customers to pay invoices within 30 calendar days but your receivables turnover shows that it’s averaging 45 days to collect payments, you may have a problem with extending credit to customers who aren’t able to pay or need to tighten up your collection processes.

On the other hand, if you have a Net 60 policy, collecting payments within 45 days means you’re exceeding your goals.

How Fiskl can help

These key financial ratios are essential analysis tools that business owners can use to quickly evaluate their company’s profitability and performance. By tracking these metrics over time, you can spot risks before they become problems and make changes to improve your bottom line.

Of course, it all starts with solid bookkeeping. Fiskl helps you stay on top of your company’s performance by giving you all the information you need to calculate important financial ratios. Each month, your transactions are automatically imported into our platform, auto-categorized and shown in accounting. You can access all of your financial data and reports in one place, making it easy to track your progress over time and identify areas for improvement.

Financial ratios are an essential tool for small business owners looking to evaluate their company’s performance and make informed decisions about their finances. By tracking key ratios like liquidity, leverage, profitability, and asset management, you can benchmark your performance against others in your industry, identify areas for improvement, and proactively address potential problems before they become major issues.

Interpreting financial ratios can be complex, and it’s important to understand what is considered good, bad, or neutral for each ratio. By using a tool like Fiskl to help you track and analyze your financial data, you can gain valuable insights into your company’s performance and make data-driven decisions to help your business succeed.