Let’s say you’re bringing in more revenue than ever, but you’re still a ways off from covering all your expenses. Maybe you need more working capital to cover these costs – but how can you gain a better understanding? Financial ratios may provide the answer to this and other pressing business questions. So, then, what are financial ratios? Learn more about them below.
What are financial ratios?
Financial ratios put numbers to your business’s profitability, efficiency, liquidity, and other considerations. You may use your ratios – which you’ll often generate using other figures from your balance sheet or income statement – to identify problem areas.
They may also point to solutions, especially if you compare them with competitors’ values. It is generally a good practice to calculate them regularly to see whether you’re improving and then tweaking your operations accordingly.
9 examples of financial ratios and their use cases
The below financial ratios may help you understand your business’s financial health.
1. Working capital ratio
This liquidity ratio has the following formula:
Working capital ratio = current assets / current liabilities
This ratio may tell you whether your cash flow is strong enough to cover your immediate expenses. You’re typically safe if your ratio is at least two, unless you’re keeping cash you could instead put toward your business or dividends.
If your ratio is between one and two, you may not have enough cash to repay your short-term debts. A small business loan may help – although it introduces long-term debt, it typically takes care of your short-term expenses.
2. Acid test ratio
Another liquidity ratio, the acid test (also known as the “quick ratio”) has the following formula:
Acid test ratio = (current assets – inventory – prepaid expenses) / current liabilities
This ratio may tell you how easily you could pay off your expenses by converting certain assets to cash. The greater your ratio, typically the less trouble you’d have liquidating your assets to cover expenses. You may take ratios of one or greater as an indication that you are able to cover your costs. Otherwise, you’ll likely need to obtain more capital.
3. Earnings per share (EPS)
This profitability ratio, which you’ll also see abbreviated as EPS, has the following formula:
EPS = net income / weighted-average number of outstanding common shares during the year
You may have to share your EPS value with lenders when you apply for small business funding. The greater your EPS, the more that lenders may feel certain you’ll have the profits to repay your debts. Outside a lending context, a larger EPS value typically indicates that each of your shareholders is earning more money on each of their shares.
4. Debt-to-equity ratio (D/E)
A leverage ratio, the debt-to-equity ratio (also known as “D/E”) has the following formula:
D/E = total business liabilities / (total business assets – total business liabilities)
Debt-to-equity ratios between two and four are typically common and often considered healthy. Values on the higher end of this range tend to show that you’re taking out enough loans to expand your business in ways that generate revenue.
Too high, though, and you may be taking on debt faster than you can repay it. Values on the lower end typically tell potential lenders that you have extra money in case you fall behind on debt repayments. Too low, though, and you’re likely not pursuing enough funding to grow.
5. Price-earnings ratio (P/E)
The price-to-earnings ratio (also known as “P/E”) can help investors understand your company’s value. Its formula is as follows:
P/E = share price / EPS
The potential ways to use P/E are best understood with an example. Let’s say that you closed trading with a stock price of $50. Let’s also say that your EPS – which always covers a 12-month period – is $10. In that case, your P/E is five, which is generally viewed favorably. Investors have been known to accept P/E values up to 20 as long as other indicators suggest future profitability.
6. Return on equity (ROE)
This profitability ratio measures how well your company uses its shareholders’ money to turn a profit. Its formula is as follows:
Return on equity (ROE) = net income / total shareholder equity
Generally, the greater your ROE value, the more effectively you convert shareholder money into profits. You should aim for your ROE to increase over time. If it does, you’ll know that as your profits increase and your shareholders get more of it, you’re likely turning those profits into more profits.
7. Return on investment (ROI)
Another profitability ratio, return on investment (ROI) is the one you’re most likely to hear in everyday speech. Its formula is as follows:
ROI = (current value of investment – cost of investment) / cost of investment
Your ROI may tell you whether your investment has generated a profit or a loss. It may also tell you the magnitude of that profit or loss. For example, an ROI of four is generally considered to be a large profit, whereas an ROI of 0.5 is generally considered a small profit. Any negative ROI values show a loss.
8. Days sales in inventory ratio
An efficiency ratio, the days sales in inventory ratio has the following formula:
Days sales in inventory ratio = 365 days * average inventory / cost of goods sold (COGS)
This figure may tell you how many days you’re holding onto your stock before you sell it. A lower ratio typically means you’re more efficiently turning your stock into cash. A higher ratio typically means your inventory is taking longer to convert to cash, which generally does no favors for your cash flow.
9. Asset turnover ratio
Another efficiency metric, the assets turnover ratio has the following formula:
Asset turnover ratio = Net sales / Average total assets
Generally, the greater this ratio, the more efficiently you’re using your current and fixed assets to generate revenue. A low ratio may indicate that you’re not using your fixed equipment productively or that your inventory is outdated. It may also indicate that your sales are low.
Why use financial ratio analysis?
Financial ratio analysis – as in, calculating the above ratios and considering what they might mean – may help you track your business’s performance. It may also help you compare your performance to that of competitors.
For example, let’s say you figure out that your D/E value for 2021 was 3.1. That means you’re properly taking on loans to expand your business, though maybe you don’t immediately have the money to repay them. But this figure is in the healthy range, so you’re likely to have that money eventually.
Next, you look at a competitor. You find that the competitors D/E values fell from 3.74 in 2017 to 2.63 in 2019. This generally means that, over time, the competitor's debt shrank in comparison to its equity. And since you’re currently at 3.1, based on the above example,, you may follow the competitors' successful strategies to lower your ratio too.
Small business loans can help your financial ratios
Many financial ratios hinge on whether your business may use its existing money to repay its debts. You may want to consider taking out small business loans to cover your expenses and fund growth.
SBA 7(a) loans, for example, have low monthly payments given their long terms and low interest rates. You may consider applying through SmartBiz®. Check now whether you’re pre-approved* for SBA 7(a) loans that may help you act on what your financial ratios tell you.
