The next time you take a look at your financial statements, consider taking a few minutes to calculate these simple financial ratios.
Looking at all of the numbers on your financial statements can be a little overwhelming. There’s a lot of information and sometimes it’s difficult to focus on what the best measures are for your business health. That’s where knowing the best financial ratios for a small business to track comes in.
Investors and banks use financial ratios to judge the strength of a business. They’re also used by financial auditors who want insight into a company’s financial statements. However, they can be just as useful for small business owners.
We’ll cover exactly what a financial ratio is, the seven best financial ratios for a small business to track, and how to get the most insight out of your financial ratios.
Simply stated, financial ratios are tools that can turn your raw numbers into information to help you manage your business better. Many small business owners look at gross sales or net income on a regular basis, but those figures can only tell you so much. Financial ratios help you read between the lines, providing insight from seemingly inconsequential numbers.
Financial ratios are a type of key performance indicator (KPI). While there are a number of KPIs you can choose to track, financial ratios only use information that can be found on your financial statements. Some other KPIs may use data that you need from other sources, like website traffic and customer satisfaction scores.
Why Measure Financial Ratios?
There is a lot of data that you’re processing as a business owner. Financial ratios can help you focus on the different health aspects of your business—cash flow, efficiency and profit. They can be used to analyze trends, compare your business to competitors and measure progress towards goals.
Essentially, financial ratios make it easier to stay up-to-date on your business health.
The Best Financial Ratios for Small Businesses to Track
There are a lot of ratios that you can track, but to keep from getting overwhelmed, you should stick to tracking a shortlist of ratios. These are the ratios you’ll want to have on that short list:
1. Cash Flow to Debt
(Net Income + Depreciation) ÷ Total Debt = Cash Flow to Debt Ratio
Small businesses make money every month, but still have cash flow problems. Why? Much of their cash is going towards debt repayment. This is where the cash flow to debt ratio can be a useful red-flag predictor—since weak cash flow is a main reason for small business failure.
Debt usually doesn’t materialize as a liquidity problem until its due date. Maybe you borrowed money from a friend or family member to get your business up and running. As long as you’re not making payments, it can be easy to ignore that looming repayment date. All of a sudden you need to repay the loan and you don’t have the cash flow to do it.
Rather than risk alienating the people who were generous enough to help you get your small business off the ground, use the cash flow to debt ratio to keep an eye on cash flow. The closer you get to the maturity date of your loan,Continue reading