Financial Ratios

As a business owner financial data is something you have become all too familiar with. Every month you take the necessary steps to ensure your financial data is current and accurate. First, you enter the data entry into your business’ accounting system. Then you have your accountant review the books. Your accountant performs the closing process and prepares a set of financial reports, or financial statements. You take the time to complete these steps because having accurate books is not only important but necessary. However, are you utilizing your financial data to better your business? This is where financial ratios come into play. But what are financial ratios, and why are they important?

What are Financial Ratios? 

Financial ratios measure quantitative data from a business’ financial statements. The calculations for financial ratios come specifically from the balance sheet, income statement, and statement of cash flows. Comparing the ratios to industry averages and standards, and internal trends is beneficial.  In doing this, it shows insight into a business’ performance, profitability, and financial health. In lament terms, financial ratios turn your business’ data into information that helps you manage your business better.

Financial Ratio Categories

There are five major categories of financial ratios. They are:

• Liquidity Ratios
• Activity Ratios
• Leverage Ratios
• Profitability Ratios
• Market Value Ratios

Liquidity ratios measure the ability of a business to pay off its short-term debt. The ratios help to determine if a business can use its current assets to cover its current liabilities. Common liquidity ratios are the current ratio, quick ratio, and cash ratio.

Activity ratios measure how efficiently a business is using and managing its resources to generate revenue. Often, these ratios are known as efficiency ratios. They are useful for comparing a business’ performance trending over time. Common activity ratios are accounts receivable turnover ratio, total asset turnover ratio, and days payable outstanding.

The next category of financial ratios is leverage ratios, also known as solvency ratios. These ratios measure how much debt a business uses to fund its operations. Common leverage ratios include the debt ratio, debt-equity ratio, and interest coverage ratio.

Profitability ratios measure a business’ ability to create earnings relative to its sales, operations, balance sheet assets, or shareholder’s equity. With these ratios, the higher the ratio result, the better. Examples of profitability ratios are gross profit margin, operating margin ratio, return on investments ratio, and return on asset ratio.

The last category is market value ratios. These ratios measure and analyze the current share price of a publicly held business’ stock. Examples of these ratios include earnings per share ratio, price earnings ratio, and book value per share ratio.

Why are Financial Ratios Important?

Financial ratios are useful tools for both internal and external users of a business. These ratios provide important information about a business’ performance. They help evaluate a business’ financial health. Also, ratios provide understanding of how a business is performing in comparison to its competitors. For example, management can use them to determine strengths and weaknesses of the business. Allowing for improvements to areas of weakness. As well as capitalizing on areas the business thrives in.

Financial ratios provide businesses with tools to assist in decision making. This ultimately helps a business achieve its goals. Our team is here to help if you need assistance with financial ratios!

Contributed by Elizabeth Partlow

Key Performance Indicators

Key performance indicators (KPIs) are performance measurements that determine how well a business is achieving its objectives. KPIs evaluate the success of a business and they often differ amongst industries. They help to determine a business’ strategic, financial, and operational achievements. KPIs also provide understanding, at all levels of a business, when it comes to making business decisions. As a small business owner there are many common performance indicators that assist in achieving the business’ goals.

Revenue Growth

Revenue growth KPIs measure how sales increase or decrease over time. Common periods are month-to-month, or from one year to the next. Revenue growth analysis can be broken down into more detail, by customer type. A business can determine the revenue growth rate by dividing the revenue from one period by the revenue from a subsequent period. Then subtracting one, and then multiplying by 100 to determine a percent.

Revenue Growth Rate = ((06-30-22 Revenue – 06-30-21 Revenue) / 06-30-21 Revenue) * 100

If the revenue growth rate is positive, the business is growing. If it is negative than there may be a serious problem.

Gross Profit Margin

Gross Profit Margin KPIs measure the profit a business makes on each dollar of sales before expenses. It depicts how well a business is performing. Profit margins are crucial KPIs for a business. A business’ gross profit margin should increase as the business grows. If the gross profit margin decreases, this can indicate trouble. To calculate the gross profit margin the cost of goods or services sold is divided by the revenue, then multiplied by 100. By monitoring the gross profit margin regularly, it helps to identify trends. In doing this, any major changes are identified and then mitigated if need be.

Accounts Receivable Turnover

The accounts receivable turnover is a KPI that measures how quickly your business collects on outstanding receivable accounts. It essentially tells you how quickly your customers are paying their invoices. Common timeframes for customer payments are 30, 60 or 90 days. Customers paying their invoices on time helps to ensure a steady and stable cash flow. Monitoring this KPI helps to identify any problem areas, such as slow paying customers and inefficient invoicing processes.

There are many key performance indicators that are common amongst small businesses. They help a business achieve its goals and provide insight on the overall health of the business. Our team specializes in developing and implementing KPIs and is here to help!

Contributed by Elizabeth Partlow

Mention the word budget to most business owners, and instantly their hands become clammy. Budgets often get a bad rap because planning one can be a tedious task. However, the benefits of a budget, far out-weigh, the dread many associate with the word. A budget is an essential tool for every business: big and small. In simplistic terms, a budget is a projection of revenues and expenses in a future period. Budgets serve as a ‘blueprint’ and aid in the success and growth of a business.

Goal Setting

Goal setting assists in achieving success and growth for your business. It is important to have long and short-term goals. Creating a budget can help you reach the goals you envision for your business. Budgets can also help you focus on your business’ goals. It is common for business owners to get caught up in the daily grind, forgetting about the big picture. Often leading to inefficiencies in resource usage. Reviewing your budget regularly allows you to ensure your business is on track to meet its goals.

Measuring Performance

Budgets can measure the performance of a business. Comparing a current budget to previous data can be a great way to track your business’ performance. These comparisons tend to make trends more visible. Often indicating areas needing improvement. Identifying areas of improvement allows business owners to find and implement solutions. Ultimately, helping a business to optimize its efficiency.

Decision Making

The decisions you make daily as a business owner affect the success of your business. Having a budget in place helps prepare you to make important decisions. It provides you with knowledge of the ‘ins and outs’ of your business. For example, an employee wants to attend a conference to develop their skills. Having a budget in place allows you to readily know whether this request is feasible or not.

Budgets are a great tool for businesses to use. The thought of creating one may seem like a daunting task, but it does not have to be. Cheryl Jefferson & Associates is available to assist you with your budget needs.

Originally written by Jamie M. Shryock, CPA

Updated and additional content provided by Elizabeth Partlow

Working capital is the difference between a company’s current assets and its current liabilities.  Current assets include cash, inventory, receivables, and other assets which are expected to be turned into cash within one (1) year. Current liabilities include accounts payable, loans of one year or less, and other liabilities which are expected to be paid off within one year. Working capital is important because it allows management to see if the business is remaining solvent in accordance with its day-to-day operations.
 

What does this mean to a business? 

Having working capital is crucial for a business because it impacts short-term operations and long-term goals. Working capital measures a company’s operational efficiency, and short-term financial health. If a company’s current assets do not exceed its current liabilities, it could go bankrupt. Positive Working capital indicates that a company can fund its current operations. On the other hand, high working capital is not always a good thing. It might indicate that the business has too much inventory or is not investing its excess cash. A business must be able to pay its vendors on time. If not, cash will need to be paid prior to cash being received. Also, if there is no adequate working capital, it can become difficult to receive loans from banks for expansion and growth. That is because the business would be considered a risky investment. 

What can a business do/plan to increase working capital?  

Some strategies a business can take to increase working capital are: 

1. Not financing fixed assets with cash. An alternative is using long-term loans or leasing fixed assets. 
2. Have a line of credit (LOC). Business owners will want to keep this to a minimum. It will only work for the very short-term and should not be the business’ main source of cash.
3. Owners can loan personal money to the business. The related party loan will be recorded as a long-term liability.
4. Replace short-term debt with long-term debt. This can help in the near term, but payments will still need to be made on the long-term debt. 
5. Issue more equity. Increases cash on hand.

Conclusion 

Working capital is an essential part of a business and it is very important to manage it well for its success. There is no single formula that works for every business because every business is unique and has different necessities.  If your business needs to maintain healthy working capital levels, we can help. 

Originally contributed by Jamie M. Shryock, CPA 

Updated and additional content provided by Takeshi Aida