How do you know if your business is in step with its competitors? Or, that you’re in a good position to seek financing? For growing companies hoping to sustain profit margins, expand or improve everyday operations, incorporating routine financial ratio analysis is an important practice at any stage or size. By evaluating key financial ratios such as the current ratio, gross profit margin or debt-to-equity ratio, for example, business owners can benchmark against industry standards, assess strengths and weaknesses and make strategic decisions for the future.
Financial Ratios Paint a Bigger Picture of Your Business
Your numbers, at face value, can provide a lot of information. However, understanding the relationship between certain numbers or variables—e.g., equity versus debt or assets versus liabilities—gives you a better snapshot of your operational efficiency, liquidity, solvency and profitability.
That’s where financial ratios come into play.
Financial ratios are numerical comparisons derived from your financial statements—the balance sheet, income statement and cash flow statement. These ratios encapsulate information into digestible metrics that can be measured and tracked over time. They also enable your stakeholders, such as investors, lenders or leadership, to make informed decisions and benchmark against industry standards.
How Often Should You Calculate & Analyze Financial Ratios?
There are many different kinds of financial ratios, from profitability ratios to valuation ratios, all of which can be useful at different intervals.
When measuring operational efficiency or profitability, for example, quarterly ratio calculations and analysis are helpful to understand if performance is declining, improving or staying the same. These are easily calculated by your accountant or finance team when creating your financial statements. However, you may want to analyze more specialized ratios for specific events, such as financing.
Consider taking a closer look at your financial ratios when…
- Applying for financing from a bank or lender. Lenders use ratios like debt-to-equity to assess your creditworthiness.
- Starting your budgeting cycle. Ratios help you set benchmarks for financial goals and highlight your areas of strength or vulnerability.
- Evaluating major business decisions. Your financial ratios can help you determine if a future transaction or major investment is even possible for your business.
- Monitoring performance against your industry. Compare profitability and efficiency ratios against your competitors to detect risks or major disadvantages.
- Reporting or adhering to regulations. Whether you’re reporting for investors or for compliance purposes, you may be required to consistently provide specific ratios.
- Fixing cash flow issues. Ratios can help you diagnose the issue behind your cash flow crunch.
Your Financial Ratios Cheat Sheet: 11 Ratios for Business Owners
There are hundreds of ratios that businesses have at their disposal, but it’s easiest to start with the most common ratios and get more specific based on your business model, industry and strategic objectives.
These financial ratios incorporate liquidity, solvency, profitability and efficiency both for private and public companies. While your business may not use all of these ratios, they’re helpful to know for a better overall business understanding.
1. Current Ratio
The current ratio is a liquidity ratio that measures your company’s ability to meet its short-term obligations with its short-term assets. A higher current ratio indicates a stronger liquidity position, essential for sustaining operations and seizing growth opportunities.
Calculation: Current Ratio = Current Assets / Current Liabilities
Note: If you want to dig deeper into liquidity, you can also assess your cash conversion cycle. While this is not a ratio, it does measure how quickly your business converts investments, such as inventory, into cash. You can calculate this by adding the days your inventory sits without being sold to the days it takes to collect receivables. Then, subtract how long you defer payments to your suppliers.
2. Debt-to-Equity Ratio
This solvency ratio assesses your financial leverage by comparing your company’s total liabilities to your shareholders’ equity. It provides insights into how you’re financing operations and growth and how much reliance you put on equity versus debt financing. A lower debt-to-equity ratio is generally preferred, because it signals less risk.
Calculation: Debt-to-Equity Ratio = Total Liabilities / Shareholders’ Equity
3. Gross Profit Margin
The gross profit margin is a profitability ratio that reveals the percentage of revenue that exceeds the cost of goods sold (COGS). It underscores the efficiency of production processes and pricing strategies. A higher margin indicates better profitability and cost management.
Calculation: Gross Profit Margin = (Revenue – COGS) / Revenue * 100
4. Return on Equity (RoE)
For public companies, RoE is a measure of profitability in relation to shareholders’ equity. It indicates how effectively management is using equity to generate profit, so businesses should strive for a higher percentage.
Calculation: Return on Equity = Net Income / Shareholders’ Equity * 100
5. Inventory Turnover Ratio
This efficiency ratio measures how quickly your company sells and replaces its inventory within a given period. A higher turnover indicates efficient inventory management and sales performance, reducing holding costs and freeing up capital.
Calculation: Inventory Turnover Ratio = COGS / Average Inventory
6. Net Profit Margin
The net profit margin is a critical profitability ratio that indicates the percentage of revenue that remains as net income after all expenses, taxes and interest payments are deducted. It provides a comprehensive view of overall profitability and operational efficiency.
Calculation: Net Profit Margin = Net Income / Revenue * 100
7. Return on Assets (RoA)
RoA measures how efficiently your company’s assets are being used to generate profit. It reflects the ability of management to convert investments in assets into earnings, offering insights into the productivity and asset utilization of the business.
Calculation: Return on Assets = Net Income / Total Assets * 100
8. Quick Ratio (Acid-Test Ratio)
The quick ratio is a more stringent liquidity ratio than the current ratio, as it excludes inventory from current assets. It assesses the capacity to meet short-term obligations with the most liquid assets, providing a clearer picture of immediate liquidity without relying on inventory liquidation.
Calculation: Quick Ratio = (Current Assets – Inventory) / Current Liabilities
9. Asset Turnover Ratio
This efficiency ratio evaluates how effectively your company uses its assets to generate sales. In other words, it signals how well management leverages investment in things like production facilities, equipment, intellectual property and other assets to generate revenue. A higher asset turnover ratio suggests that the company is using its assets efficiently to increase sales, indicative of operational effectiveness.
Calculation: Asset Turnover Ratio = Revenue / Average Total Assets
10. Customer Acquisition Cost (CAC) Ratio
The CAC ratio is a marketing ratio that calculates how much a company spends to acquire each new customer. It offers visibility into the efficiency of sales and marketing investments against revenue growth. A lower ratio is typically preferred.
Calculation: CAC = Sales & Marketing Expenses / Number of New Customers
Note: You can also compare CAC to lifetime customer value (LTV) to see how the price of acquiring customers compares to customer value across the lifecycle.
11. Price-to-Earnings Ratio (P/E Ratio)
For public companies, the P/E ratio is a vital market valuation ratio that compares a company’s share price to its earnings per share (EPS). It provides investors with insights into market expectations and the company’s growth prospects. A higher P/E ratio may indicate that the market expects future growth in earnings.
Calculation: Price-to-Earnings Ratio = Market Price per Share / Earnings per Share (EPS)
Implementing Financial Ratio Analysis in Your Business
To harness the full potential of financial ratios, business owners should integrate them into regular financial reviews and strategic planning sessions. Here’s a streamlined approach to applying financial ratio analysis effectively:
- Consistently track financial ratios over time (at least quarterly) to monitor financial performance trends.
- Compare financial ratios against published industry benchmarks to gauge business standing relative to standards.
- Establish internal ratio-based targets aligned to financial objectives and strategic priorities.
- Analyze trends between different ratios to identify deeper issues impacting performance.
- Make financial ratios central in company-wide metrics and KPIs across departments.
- Relate staff responsibilities like inventory management to broader ratio metrics.
- Use ratios as proactive measures, not just compliance reporting.
- Engage fractional financial advisors or accountants to delve deeper into ratio analysis, interpret complex findings and improve strategy.
Get Support In Analyzing Your Numbers
Entrepreneurs can transform raw numbers into action through robust ratio analysis. However, your key financial ratios may be slightly different or more complex. In order to set the right targets for your business, it’s best to consult with an expert. Paro’s on-demand accounting and finance experts are available to help you decode your financial statements and assess your company’s standing against the competition. Match with a highly-vetted expert in just hours.
Glossary of Terms:
- Current assets: Cash and assets that can be converted to cash within a year (e.g., cash, accounts receivable, inventory)
- Shareholders’ equity: The corporation’s total assets minus its total liabilities, also called stockholders’ equity or owners’ equity
- Cost of goods sold (COGS): Direct production costs of goods produced by the company, such as raw materials, direct labor, operational overhead
- Net income: The income left after subtracting all expenses from revenues over an accounting, also considered the bottomline period
- Total assets: Everything the business owns that holds economic value, including current assets and long-term assets like property, plant & equipment
- Earnings per share (EPS): The company’s net profit allocated to each outstanding share of common stock, demonstrating profitability on a per-share basis
