Why Look at Financial Ratios?
Financial ratios provide insight into your business recent performance. But it’s way more than that. It provides detailed insight into your operational effectiveness and efficiency as well as a great benchmarking tool against your competitor and the industry average.
Your ratios show the details of your company’s operational strengths and weaknesses in a way that your revenue or profit figures simply can’t. For example, your revenue has been showing positive figures over the past 3 months but when you take a look at your inventory turnover rate, you found out that it takes 3 – 4 days longer than expected to sell your inventory. As a result, you have excess of inventory for the current month.
There are a wide range of financial ratios that a small business owners can look at but it is very much dependent on your goals and your type of business. Not single ratio will be for you to keep track of.
Which Ratios to be Prioritized?
Not all ratio are created equal as not all of them would have a direct relationship with your daily operations. However, as a business owner, it’s invaluable that you keep tabs on the following 5 ratios to help you make necessary changes to improve your business efficiency and effectiveness.
- Current Ratio
Calculated by putting your company’s Current assets against its current liabilities, Current Ratio provides a great insight to your company’s short term financial position. Especially, your business’ ability in meeting its short term financial obligations such as setting your accounts payable, repaying your loans, or meeting its interest expenses.
A ratio lower than 1, means that you don’t have enough finances to match every $1 of your short term debt (one year or less) but doesn’t mean it’s problematic. It becomes dangerous if the ratio is too low and stays at that level over time. For example, if your current ratio is at .65 or below and stays the same, that indicates that you are more likely using your revenues to cover your short term debts.
On the other hand, if the ratio is really high, say more than 2, it indicates that your business is either not using its current assets efficiently (such as really high receivables or bloated inventory), unable to secure the right financing, or is not managing its working capital well.
- Inventory turnover rate
It’s the ratio of your company’s cost of goods sold (COGS) against its average inventory. Or another way of looking at it, how many times do you need to re-stock your inventory to match your company’s sales within a certain period. Such as within 1 fiscal year or a month. The preferred ratio is between 4 – 6 where you are able to comfortably replenish outgoing stocks without losing sales opportunities. This ratio will change based on the industry you are in thus, it’s important to know what is the most reasonable level
This analysis tool provides a great insight into your sales and marketing efforts as well as your inventory and cost management. A low number, say 3 or below, could be a result of overstocking your inventory or lack of staff. Whereas a really high number, say 9, may mean that your inventory level is unable to keep up with sales as a result of poor inventory management.
- Quick Ratio
This ratio evaluates the liquidity of your business without the need to sell your inventory (which is also its biggest difference with Current Ratio) by taking a look at your most liquid assets such as cash reserves, cash equivalents, and short term receivables.
In particular, your cash level and short term receivables are the most important elements with a quick ratio analysis. That enables you to meet your day to day obligations including unforeseen expenses. For example, if your company needs to send one of your vehicles for repair, would you have enough cash reserve to settle it?
- Average Customer Sales
The goal of this ratio is to make you see the potential revenue you might miss out on. It might seem trivial at first until you delve deeper into how much each customer actually spends on your products or services. For example, if you are an online fashion retailer you might consider offering bundles like pants & belt or jacket & scarf. Another example, if you are selling a web based CRM, consider upselling a monthly subscription for a cold-calling service to get additional monthly revenue stream.
- Debt to worth ratio
By comparing how much you owe to how much you own, you can see how dependent your business is on borrowed finance to keep it going. If the ratio’s number is too large, say 2 or larger, you increases your risk rating in the eyes of lenders. Making them reluctant to work with your business. However, this can be mitigated by having a strong track record of meeting your short term debt obligations and a healthy monthly revenue. For a business that is still growing, lenders tend to focus on your monthly revenue when they are assessing your company’s ability to stay afloat and grow. As a rule of thumb, a minimum of $8,500 monthly revenue is recommended so that lenders are willing to support your business growth.
How will these ratios affect your business?
They assess and evaluate your company’s short term financial health so that you can take the right measures to improve it.
Firstly, it helps you choose the right financing to help with your business growth. A high current ratio indicates that you are not securing the right financing or your business needs and at the same time, showing that you have the pipeline to take on debt. For example, instead of relying a short-term line of credit, your business is better suited to secure a term loan that will allow you take on bigger projects.
Secondly, it helps you secure the right financing without incurring high borrowing cost. Lenders, when dealing with growing businesses, look at your monthly revenue stream as the primary measuring stick for your business worthiness when they consider financing your business. Coupled with paying your dues in a timely manner, would put you in an advantage when seeking the right financing for your business growth.