It’s human nature to measure and compare. Whether it’s counting steps in the fitness world or tracking single-season passing yards in the sports world, measuring our progress against ourselves and others helps us keep track of how we’re doing.
As an owner of a small business, you can do something similar with financial ratios. Financial ratios help you measure how well your business is performing, and just as importantly, can let others, such as lenders and outside investors, evaluate your business’s financial health.
Looking at trends in your ratios over time and comparing them to industry averages can be instructive. There are different categories of financial ratios, all derived using data from a company’s financial statements.
These ratios measure whether your business is earning an adequate return on sales, total assets, and invested capital. For example, profit margin (the ratio of net income to sales) measures your company’s return on the sales dollar and is a key profitability ratio.
ASSET UTILIZATION RATIOS
Also known as “turnover ratios,” asset utilization ratios measure how efficiently your business is using its assets. For example, the receivables turnover ratio indicates how fast you collect cash from credit customers. The higher the ratio, the faster your collections. Similarly, the inventory turnover ratio measures how fast a company sells its inventory.
Liquidity ratios illustrate whether your business has sufficient assets to pay outstanding short-term obligations as they come due. The current ratio (current assets to current liabilities) is a commonly used liquidity ratio.
DEBT UTILIZATION RATIOS
A key ratio in this category, debt to total assets helps you to determine whether the debt your business carries is manageable. Since an inability to pay off debts may result in a business’s failure, this particular ratio is a critical indicator of the long-term financial sustainability of a business.