Financial Ratios Are How You Know If What You're Doing Is Working
Being an entrepreneur for more than 30 years has taught me how important it is to track data about my business. But, I didn’t always take the same approach.
During the early years, I was so busy trying to build my company that I didn’t take much time to stop and look at the results of my efforts. That led to some under-calculated decisions that cost me time and money. I needed to use ratios to check my progress.
What are financial ratios used for? At my current company, Patriot Software, I use all kinds of data to guide my next moves. Financial ratios are an important part of reviewing performance to see what’s working.
As a small business owner, you can use simple ratios to grow your company. By reflecting on past efforts, you can make more informed decisions. And, you can show your financial ratios to lenders and investors to gain capital.
Two major types of business metrics are profitability and financial leverage ratios. You will find explanations of several financial ratios with examples below.
1. Profitability ratios.
As a small business owner, you need to know how profitable your company is. Without a clear picture of your bottom line in business, it can be hard to talk with lenders and make business decisions.
Use profitability ratios to look at your business’s ability to generate income. With profitability ratios, you compare your earnings to expenses during a specific time period. Usually, a higher ratio indicates a healthier business.
The following are common profitability ratios:
- Gross margin ratio
- Profit margin
Use these ratios to look at your business's performance from different points of view.
Gross margin ratio.
The gross margin ratio compares your business’s gross margin to its net sales. This ratio measures how well you sell inventory. And, it shows the percentage you should use to mark up products. To find your business’s gross margin ratio, use this formula: Gross Profit / Total Revenue = Gross Margin Ratio.
The gross profits are the total earnings minus the cost of goods sold (COGS, or the expenses that go directly into operations). The gross margin ratio will tell you how much more you sell an item for than its original cost.
For example, you have $50,000 in gross profits and your cost of goods sold is $30,000. Using the formula, your gross margin would look like this: ($50,000 - $30,000) / $50,000 = 40 percent Gross Margin.
The gross margin ratio shows you’ve priced your offerings 40 percent higher than the amount you paid for them. You will have 40 percent of your total revenue left over after paying the cost it takes to produce the items.
Net profit margin.
The net profit margin shows how much of your earnings turn into profit. In other words, you can see the percentage of earnings left over after paying expenses. To find the net profit margin, subtract expenses such as COGS, operating costs, taxes, interest and other business-related costs. Use this formula to find the net profit margin: (Total Revenue - All Expenses) / Total Revenue = Net Profit Margin.
Let’s say you have $100,000 of revenue and your total expenses add up to $80,000. Your net profit margin formula looks like this: ($100,000 - $80,000) / $100,000 = 20 percent Net Profit. Your business keeps 20 percent of its earnings. The rest of the earnings (80 percent) go back into business operations.
ROI (return on investment).
As a small business owner, you want to make sure your investments result in more money flowing into the company. Return on investment shows how successful your investments are. Use this formula to find the ROI: (Gain from Investment - Cost of Investment) / Cost of Investment = ROI.
ROI helps you consider which efforts are worth your time. If you’re pouring resources into things that aren’t helping your business grow, you need to make changes. Return on investment can help you see where adjustments should be made.
For example, you spend $500 on a marketing campaign that results in $600 in sales. This would be your business’s ROI: ($600 - $500) / $500 = 20 percent ROI. You made 20 percent profit on your investment.
2. Financial leverage ratios.
You rely on debt and equity financing to grow your business. Financial leverage ratios are used to look at how much business capital comes from debt. They can also assess how well your company pays debts.
The following are common financial leverage ratios:
- Debt to asset ratio
- Debt to equity ratio
- Interest coverage ratio
Too much debt poses risks to your business. And, it is harder to get financing when your business debt is out of control. Using financial leverage ratios can help with your business debt management. You can see how your debt compares to earnings and whether the loans you take on are growing your company.
Debt to asset ratio.
The debt to asset ratio measures the percentage of assets financed with debt. It compares assets financed with borrowed money to assets paid off. The debt to total assets ratio shows how you've gained assets over time. Do you use company profits and investors? Or, do you take on debts to buy assets?
The fewer assets you acquire with debt, the better. Here is the debt to total assets ratio: Total Debt / Total Assets = Debt to Asset Ratio.
Let’s say you want to apply for a loan to grow your business. You currently have $50,000 of assets and $25,000 of debt. Your debt to asset ratio looks like this: $25,000 / $50,000 = 50 percent Debt to Assets. This means that 50 percent of your assets are financed with debt. The bank considers this information to decide approval, limits, interest rates and payment terms.
Debt to equity ratio.
The debt to equity ratio looks at how much debt you have compared to the capital you provide. The ratio measures debt as a percentage of equity. The debt to equity ratio shows how much equity is available to cover debts. The more debt you have compared to equity, the riskier you are to lenders and investors. Use the following formula to find your debt to equity ratio: Total Debt / Total Equity = Debt to Equity Ratio.
Business equity is the difference between your total assets and total liabilities. It represents ownership in a company. If you are a sole proprietor, you are entitled to all of your business’s equity.
You can use the debt to equity ratio to gain capital. Lenders and investors look at this metric to determine their level of risk in giving you money. For example, you have $100,000 of equity and $40,000 of debt. Your debt to equity ratio would be: $40,000 / $100,000 = 40 percent Debt to Equity. Your debt takes up 40 percent of your equity. A lender would look at your debt to equity ratio before approving you for a loan.
Interest coverage ratio.
The interest coverage ratio shows how easily your business can pay interest expenses on debts. It reveals how many times over you could pay outstanding debts with your profits. The lower the interest coverage ratio, the more debt expenses you have compared to earnings. If you have a low interest coverage ratio, lenders could question your ability to pay debts. This might make it difficult to get approved for loans and receive favorable payment terms.
A company consumed by debt can’t grow. For this reason, investors also consider your interest coverage ratio to check your creditworthiness. Use this formula to find your interest coverage ratio: Earnings Before Interest and Taxes (EBIT) / Interest Expenses = Interest Coverage Ratio.
Earnings before interest and taxes are your net profits plus interest and tax expenses. Another way to look at EBIT is that it shows earnings minus expenses, except for interest and taxes. For example, your EBIT is $80,000. You pay $40,000 in interest and taxes. This is what your interest coverage ratio would look like: $80,000 / $40,000 = 2 Times Interest Coverage. The calculation shows that you can pay your debt expenses two times over with your business’s profits.
What are financial ratios used for?
Small business financial ratios can be used for many different purposes that help you run your company. You can use ratios to look at performance and make decisions. And, you can show ratios to lenders and investors when seeking capital.
Both profitability and financial leverage ratios can help you improve operations. Profitability ratios show you how well your business generates profits. Financial leverage ratios reveal how well your business manages debts.
No matter the size of your business, it’s important to track and review your progress. Being aware of how effective your efforts are sets your business up for growth and success.