Understanding Common Financial Ratios

Your business’s balance sheet and income statement reveal a great deal about the financial state of your business. But they are far from the only important set of metrics. You can use many common financial ratios to drill down into the health of your business.

Gross margin ratios, for example, are extremely important in determining whether the cost to produce your product or service is comfortably and efficiently covered by the revenue those products or services generate. An excessively slim gross margin ratio — say 2 or 3 percent — can mean you are very close to losing money on sale.

It can be very helpful to compare your gross margin ratios with your competitors, industry and sector. If your competitors or industry enjoys gross margin ratios of 20 percent on average and you clock in at 15 percent, you need to determine why their margins are more robust than yours. Are you spending more on elements of your COGS? Pricing below your competitors?

If you have different business lines, margin ratios can also show you the relative profitability of different products or services in your business.

All of the ratios below can provide highly important information to you regarding the financial health of your small business:

• Gross Margin Ratio: Measures how efficiently your business generates profit from sales after accounting for direct costs (like production or materials).
  Gross Margin Ratio = (Gross Profit / Total Revenue) × 100

• Net Profit Margin: Indicates the percentage of profit relative to total revenue.
  Net Profit Margin = (Total Revenue – Total Expenses) / Total Revenue

• Return On Investment (ROI) Ratio:Also known as the “return on assets” ratio, the ROI is a profitability measure that evaluates the performance or potential return from a business project.

It allows a business owner to assess how efficiently the company uses its total asset base to generate sales. The ROI formula looks at the benefit received from an investment divided by the investment’s original cost.
ROI = (Net Profit / Investment Cost) x 100 

• Net Income or Return: This represents the profit generated by the project.
  Net Income = Total Revenue − Total Expenses

• Net Assets or Investment: Refers to the total investment made in the project.
  Net Assets = Total Assets − Total Liabilities

• Current Ratio: This ratio assesses your ability to pay short-term obligations (liabilities due within one year). Ideally, your current ratio should be greater than 1, indicating that you can cover all payables, accrued expenses and short-term debts with existing assets. It’s calculated as:
  Current Ratio = Current Assets / Current Liabilities

• Quick Ratio (Acid Test Ratio): Similar to the current ratio, it focuses on highly liquid assets (cash, marketable securities, and accounts receivable) relative to current liabilities. Note: The Quick Ratio excludes prepaid expenses and inventory.
  Quick Ratio = (Cash + Marketable Securities + Accounts Receivable) / Current Liabilities

• Debt-to-Equity Ratio: Evaluates the proportion of debt to equity in your business:
  Debt-to-Equity Ratio = Total Debt / Total Equity

• Interest Coverage Ratio: Assesses your ability to cover interest payments:
  Interest Coverage Ratio = Earnings Before Interest and Taxes (EBIT) / Interest Expense

• Inventory Turnover Ratio: Measures how efficiently you manage inventory:
  Inventory Turnover Ratio = Cost of Goods Sold / Average Inventory

• Accounts Receivable Turnover: Evaluates how quickly you collect outstanding receivables:
  Accounts Receivable Turnover = Net Credit Sales / Average Accounts Receivable