Have you recently provided your financial statements to a lender, investor, large customer or vendor? Did you wonder what they were looking for? Were you caught off guard by the questions they asked or the decisions they made?
Financial statements reveal a lot about a business. Readers of financial statements use financial information to make decisions. Those decisions can significantly impact your success – they determine whether you will get the loan, capital, or contracts needed to grow your business.
It’s important for you, the business owner, to understand what your financial statements are saying about your business. In addition to using your financial information to help you make decisions about your business, you can also get ahead of the questions coming from your lenders, investors, customers, or vendors.
There are several ratios you can utilize to help better understand what your financial statements are saying. These ratios can be calculated using information from your balance sheet and income statement.
This article lists five key financial ratios, and answers the following questions:
- What does this ratio tell me?
- How do I calculate it?
- What is a target/ideal result?
Five Key Financial Ratios:
1. Quick Ratio
- The quick ratio measures a company’s ability to pay short-term financial obligations without selling inventory.
- Quick ratio = (Current Assets – Inventory)/Current Liabilities
- A quick ratio of 1.0 indicates you are able to meet your current obligations, but nothing more.
- Benchmarks vary by industry. A lower number is a red flag regarding your ability to repay. A higher number may indicate you’re keeping too much cash on hand.
2. Working Capital
- Working capital shows how much cash is available for operations.
- Working Capital = Current Assets – Current Liabilities
- Banks will compare this with industry averages.
- A lower number may indicate financial distress. A higher number may indicate you’re carrying too much inventory or taking too long to collect receivables.
3. Return on Assets
- Return on assets shows how effectively you use the assets of your business to generate additional profits.
- Return on Assets = Net Income/Average Total Assets
- Benchmarks vary significantly by industry, but the higher the better.
4. Gross Profit Margin
- This ratio shows how much money is left over after a company sells a product and pays for the cost of that product.
- Gross Profit Margin = (Sales – Cost of Goods Sold)/Sales
- The margin should be stable and needs to be compared with the industry averages. This ratio is important in setting your prices.
5. Net Profit Margin
- Net profit margin shows how much profit remains after all expenses have been deducted from total revenue.
- Net Profit Margin = Net Income/Revenue
- This ratio should be tracked over time and trends should be stable or increasing.
- Significant increases in revenue without increases in net profit margin can indicate you’re using a lot of time, energy and resources, but not gaining in profitability.
Understanding what these ratios tell you and why they’re important is key. Don’t be overwhelmed by the formulas. Your bookkeeper or CPA can easily set up a template to calculate and report on these ratios on a regular basis. Then, you’ll have the information you need to evaluate your results and make decisions for your future. You can also avoid surprises by being proactive in preparing for discussions with lenders, investors, large customers or vendors.
Once you understand what your financials are telling you, an analysis of your company’s Chart of Accounts should be done to compare these accounts with the data utilized in the report, so you have quick access to the information you need. Check out our article on how to Refine Your Chart of Accounts.
Need help calculating your ratios or reporting on them on a regular basis? We’re glad to discuss or assist- Contact TDT today.
Courtney DeRonde, CPA and Co-Managing Partner at TDT, discusses what your financials say about your business. Proactively helping clients achieve better results is our firm’s purpose. To carry that out, Courtney uses real-life experience from her work in firm leadership and her business knowledge from 17 years of serving clients to help small businesses succeed. She is recognized among others within the profession for her expertise as she presents at various conferences and seminars.