Know Your Financial Ratios

Measure Your Business's Health with These Financial Ratios

business financial graphicLarge companies use defined financial ratios to analyze the health of the organization. There are dozens of established ratios that test a variety of financial domains, including the ability to pay debt, secure stockholder funding and expand services.

Not all ratios are used by every company. Small business owners should use the following ratios that help manage day-to-day activities while still keeping an eye on growth:

Quick Ratio

This metric derives its name from the speed in which you can get out of your business. The quick ratio is cash, accounts receivable and other assets that can be quickly realized divided by your total current liabilities. This ratio tells you whether or not you can cover your debt without tapping into your inventory. It looks at a point in time for your business and determines if it is healthy at that point.

If your assets are greater than your liabilities, the quick ratio will be greater than one. Decimal ratios show that your business needs a fast infusion of cash to be strong. You may consider cashing out long-term income from things like structured settlements and annuity payments using J.G. Wentworth. If your quick ratio is more than two, this means that you have twice the capital that you need and should think about expanding your business.

Operating Margin

The second ratio of the financial triumvirate measures the income from operations divided by the net sales. The operating income is the profit after deducting variable costs of production or service delivery. If this ratio is equal to one, then there is no cost for doing business and all of the income from sales is profit. On the other hand, if the ratio approaches zero, all of the income from sales is eaten up by producing the item. Somewhere is the middle of these two extremes is a good profit margin. This ratio only looks at operating costs and before-tax sales. It does not take into consideration after-tax effects or cash assets.

There are other profitability ratios that are more robust in their analysis and work better for larger companies, but for a small business, the operating margin ratio tells you everything you need to know about your profit. Since entrepreneurial ventures are often closely linked to the owner’s net worth, things like tax bases and fixed expenses do not fit into the mix. When we drop the kids off at school, go see a client, then come home to the office, it is useless to separate out these expenses as fixed costs. Theoperating margin lets us ignore these and focus only on the profitability for one service or product.

Cash Flow to Debt

Many new businesses have failed because they did not analyze their cash flow. As a matter of fact, theU.S. Small Business Administration cites underfunding and poor cash flow as one of the main reasons a new business fails. This coverage ratio is your net income plus depreciation divided by total debt, and it is considered the best predictor of business failure. A number less than one means you cannot cover your bills without securing additional funds. A ratio greater than one but less than two is good, and anything high shows that you have surplus capital and you should start looking at investing or expanding.