Financial ratios are used in lots of different settings. External stakeholders, like lenders, may use them when processing loan requests. Managers may employ them when comparing multiple similar companies or when deciding if purchasing a business makes sense. But it is not just in these more significant situations where ratios are useful. Every small business owner in his or her attempt to continually monitor the health of their business can make use of simple to calculate financial ratios.
While there are many ratios to choose from, each with its own time, place, and caveats, I’ll highlight 6 key financial ratios here. To put this article to use in real life, you would need a set of reliable financial statements. For some ratios, you’ll need additional information that would be available from management or the notes and disclosures within financial statements. Let us get into 6 basic financial ratios and what they reveal about your business.
This ratio is simple to calculate. It lets you know how long a business can survive should all revenue stop. It is the number of months (or days if you prefer) that a company can continue to pay its operating expenses without bringing in any additional cash. This ratio is especially useful for business operations if you run a seasonal business but have a few salaried employees that stay on payroll year-round.
To compute the ratio, take the total amount of cash on hand and divide that by your annual operating expenses such as salary payments and occupancy costs. Be sure to exclude things like depreciation if your Income Statement groups this with operating expenses.
cash / [(operating expenses – non-cash expenses) / (12)] = months of operating cash on hand
What a good or bad result is will depend on your situation, but generally, try to hold three to six months of cash on hand. You want to have more in savings the riskier your business is, the less diverse your income sources are, and the harder it would be to replace your income if lost. If this goal seems daunting, try by starting to save just enough to cover two to three payrolls. Though there are industry-specific differences, a ratio higher than six months is excellent, something between four to six months is acceptable, and anything fewer than four months requires additional attention.
This ratio is similar to the above but considers instead of current cash reserves, the amount of cash available in already secured lines of credit. In the above formula sub out the cash figure for the amount of available credit you have on any current lines of credit.
Some businesses may not have a line of credit making this irrelevant, but if one exists, judge the resulting ratio based on the same criteria as mentioned for the months of operating cash on hand ratio.
amount of available lines of credit / [(operating expenses – non-cash expenses) / (12)] = months of operating costs in lines of credit
Continuing on this train of thought, consider lines of credit a bit more. As with personal finance, you don’t want to max out your credit cards or lines of credit. For one thing, it may give lenders pause when renewing your line of credit.
For this simple ratio divide the amount of credit used by the total amount of credit extended. If you are using this ratio on a business that isn’t yours, the amount of available credit will be in the financial statement’s notes, or you’ll have to ask for it if you don’t have audited financials. A ratio of greater than 85% would be very concerning, something between 50% and 85% would require further investigation and something of under 50% is satisfactory. Again, each specific industry will have ranges that are typical, so what causes worry in one industry may not in another.
amount of credit used / total amount of credit extended = percentage of lines of credit used
The working capital ratio looks at liquidity. This is how readily a business can pay its liabilities. Assets are ranked on a liquidity scale, with cash being the most liquid. Current assets are considered liquid as well, while fixed assets are not. This ratio compares your ability to pay current liabilities (those coming due in less than a year; including the current portion of long-term debt) with your current assets.
current assets / current liabilities = working capital ratio
A ratio of two to three should provide reasonable assurance. Anything lower than two, especially lower than one, should lead you to investigate more as it spells potential trouble paying down liabilities. Things like inventory and accounts receivable, included in current assets, can skew this ratio so it is useful to take a deep dive into those line items to see how liquid they really are. As a way of a second opinion, try using the Quick Ratio. This ratio removes from consideration certain items that may take longer to turn into cash like certain inventory items. One way to dive deeper into accounts receivable is to determine how quickly your receivables become cash.
Net credit sales are the number of sales your business had where it did not immediately receive cash, less any returns. Average accounts receivable is the average of the receivable balance on the first of the month and the last of the month (or whatever period you are calculating). A high ratio means you are collecting your receivables efficiently.
net credit sales / average accounts receivables = accounts receivable turnover
This ratio can be paired with the Turnover Ratio to determine if your company is collecting receivables in line with its policies or if your customers may not be creditworthy. The results of these two ratios in concert could suggest you should relax or tighten your credit policies, better screen customers you give credit to or enhance collection efforts. It can also let you know how reliable the Working Capital Ratio is likely to be.
(accounts receivable balance / annual revenue) * 365 =
accounts receivable days or the number of days it takes the business to collect an average invoice
There are more ratios used when you hire Szweda Consulting for-profit consulting. We monitor various “vital signs” of your business to ensure you are running a lean operation that can grow and that is increasingly profitable. For help with this or any other accounting matters, reach out to us at (216) 509-1561 for the best consulting and bookkeeping services.