Financial Ratios You Need To Start Tracking

Financial Ratios You Need To Start Tracking

Ratio analysis may seem minuscule in the grand scheme of things when it comes to the small business world, but trust me, it can greatly increase your chances of success. I mean, who has time time to calculate such things, and even after you do, what do they mean?

I've come up with what I believe are the top five ratios you should calculate for your small business to track, analyze, and base decisions off of. These calculations don’t need to be tracked daily, but let’s start with monthly. It’s a rather simple process once you begin and you will likely gain some awesome insight into your business.

Top 5 Ratios

Now there are many other ratios that are just as important, but here are my top five to get you started:

Current ratio = Current Assets / Current Liabilities Quick ratio = Quick Assets / Current Liabilities Profit margin = Net Income / Total sales Inventory turnover ratio = Cost of Goods Sold / Average Inventory Accounts receivable turnover ratio = Receivables Sales / Average A/R

Current Ratio The current ratio is defined as current assets divided by current liabilities. Current assets are those items that can typically be converted to cash with a one year period. Those items include your cash and cash equivalents, receivables, and inventories. Your current liabilities are those accounts that will become due within one year such as your accounts payable, payroll and sales tax payable, and short term notes payable.

This ratio is a measurement of a company's liquidity and its ability to meet its financial obligations. A ratio greater than one represents a company that can effectively meet its obligations, while a ratio less than one may present some financial trouble. Striving for a higher ratio will always make for a better financial scenario.
Quick Ratio

Similar to the current ratio, the quick ratio selects your “quick” assets (Cash, marketable securities, and accounts receivables), divided by current liabilities to calculate this measurement of liquidity. This ratio may also be referred to as the acid-test ratio. Other current assets may be involved, just remember to back out your inventories in this case.

Profit Margin

This is my favorite ratio and probably the most widely referred to by small business owners. They are always asking, “well, what is my profit margin?” It really is a simple calculation, just take your net income and divide it by your total sales.

You may also track this calculation from a gross profit perspective, known as, you guessed it, your gross profit margin. This ratio only takes into account your cost of goods sold. Simply take your total sales and subtract your cost of goods sold, and divide that back into your total sales. Either method is highly requested and both can be of equal importance to track month over month and even year over year.
Inventory Turnover Ratio

Assuming you are in a line of business that maintains certain levels of inventories, this ratio can provide great insight into inventory management. The inventory turnover ratio will tell you how many times you have sold or replaced your inventory. The calculation is your cost of goods sold divided by your average inventory. You may also use your sales and divide that by your inventory, as some prefer. Either way, you will be striving for a higher ratio, which means you are generating the most out of your inventory and effectively managing inventory levels.

Example: Cost of goods sold throughout the period were $15,000 and your average inventory was $2,500. $15,000/$2,500 = 6. Your inventory has turned over 6 times throughout the year. Trying to increase from 4 would require lowering your average inventory on hand compared to your cost of goods sold, leading to a more efficient inventory system.

Another important piece to this puzzle may be the days sales in inventory ratio. This stems from the previously calculated inventory turnover ratio. Take 365 days and divide it by your turnover ratio. That is a simple method to see the average of how long your inventory has sat in the warehouse.

Example: Based on the calculation above, 365 days divided by 6 = 60.83 This means that your inventory has sat on your shelf on average of 60.83 days. Your next phase of analysis with this calculation would be to compare this to your industry averages, hoping that you are moving inventory quicker than your peers.

Accounts Receivable Turnover Ratio

If you send invoices you are likely familiar with waiting to get a paid, or not getting paid at all in some unfortunate cases. Your accounts receivable turnover ratio is a great indicator of how well your business is able to collect on its credit extended to customers.

The accounts receivable turnover ratio is calculated by dividing your receivables sales by your average accounts receivable balance. The higher the rate, the better a company is at collecting on its receivables.

Example: Annual invoiced sales throughout the period were $25,000 and your average accounts receivable balance was $2,000. $25,000/$2,000 = 12.5. Your extended credit has been collected an average of 12.5 times throughout the period. Compare that rate throughout the period and see if it is comparable to the invoice terms you are extending to your customers.

Similar to the inventory ratio above, with the accounts receivable turnover ratio we are able to calculate the days’ sales in receivables by dividing 365 by the A/R turnover ratio.

Example: Based on the calculation above, 365 days divided by 12.5 = 29.2 days. This means that your extended credit to your customers was collected around 29 days, on average. If your terms are 30 days, this may represent that most customers have provided payment within the extended time.

Summary

Start by selecting the ratios that you can calculate on a regular basis (monthly, yearly) and start a spreadsheet to post the results. Just getting an initial base to see where your business stands compared to the industry is a great start. After some time goes by you will hopefully see your ratios trending in a positive direction that was based off of insightful, smart decision making.

Take a look at other ratios that may be relevant to your business, there are many available. Do you already calculate ratios that aren’t on the list? I’d love to hear of them!