Financial ratios help small business owners who want a fuller picture of their company’s overall financial health.
Ratio analysis takes raw financial figures and helps you uncover patterns and problems at a glance by establishing relationships between variables and providing benchmark indicators.
Within Smansha’s cash flow forecast and analysis, there are four go-to financial ratios that indicate how efficiently a business is operating and managing its financial obligations.
1. Cash-inflow-to-cash-outflow ratio
The cash-inflow-to-cash-outflow ratio, also known as your operating cash flow, reflects your company’s short-term liquidity (the cash you have on hand, or can get your hands on quickly).
This is one of the financial ratios that measures the number of times your company can pay off its current debts with cash in a set period. A high cash inflow to outflow ratio suggests that your company brings in more cash than it needs to pay off its debts. A lower one signals that your cash flow is negative and that your business may have trouble paying its debts within a set amount of time.
Calculating cash inflow to cash outflow — an example
Patty’s Pastry Pagoda sells a variety of outstanding snacks. But working in the bakery biz doesn’t always mean your company’s dough is in order. Her pagoda has high fixed costs, such as gas and electricity bills. She also has to buy enough baking supplies to keep producing pain au chocolat without a hitch. Patty has to figure out how her cash inflow to cash outflow ratio looks if she wants to make sure she has the bread to pay off her debts.
Patty’s annual cash flow is $200,000 and has $190,000 in current liabilities. This gives her cash inflow to cash outflow a ratio of 1.05, which means she’s at risk of not having enough cash to keep up with payments.
Here’s how Patty calculated her operating cash flow ratio:
cash flow ÷ current liabilities = cash inflow to cash outflow ratio
$200,000 ÷ $190,000 = 1.05
2. Current ratio
The current ratio is similar in some respects to the cash inflow to cash outflow ratio. Both measure a company’s ability to pay off obligations, but the current ratio offers more details about how a business can handle short- and long-term obligations.
The current ratio takes accounts for a company’s current liquid and illiquid assets (hence the name) with regard to its current liabilities. This ratio is also known as the working capital ratio since it shows how much capital a company has in hand after costs are factored in.
Much like the cash inflow to cash outflow ratio, your current ratio signals your ability to pay off current debts. The higher the number, the better equipped you are to make these payments. A number below one signals that you can’t afford to pay off your existing debts with the amount of cash you have.
You can also use the quick ratio to get a similar impression of your immediate cash flow. The quick ratio is similar to the current ratio, except it removes the cost of inventory from the equation. This is helpful if you want to want to exclude inventory from your estimates—say, for example, if you do not want to factor in your ability to sell your supplies to help pay off debts.
Calculating a current ratio — an example
Patty’s business is on a roll, but she’s worried about having enough cash to keep things on the rise. She’s got a kitchen filled with all the tools she needs to bake her customers’ favorite snacks. But buying all of that equipment wasn’t cheap and she had to finance these purchases as a result. Now, Patty wants to make sure she can pay for all of the machinery she bought with credit.
Patty has $275,000 in current assets since she’s got $200,000 in cash and invested $75,000 of her own money into the business when it started. She also has $190,000 in liabilities due to her loans. This leaves her with a current ratio of 1.4, which is safe enough to keep her business running—so long as there aren’t any unforeseen financial emergencies.
Here’s how Patty calculated her current ratio:
Current assets ÷ liabilities = current ratio
$275,000 ÷ $190,000 = 1.4
3. Debt-to-equity ratio
One of the financial ratios that measures solvency, the debt-to-equity (D/E) ratio (also known as your as risk, gearing or leverage ratio) shows your company’s assets versus the amount of debt it has taken on. It determines how much your company’s assets are worth relative to the amount of debt it has, which can help you understand your attractiveness to investors and lenders.
In essence, it shows you how much debt you use to run your business. D/E ratio also helps you stay on track with debt, since you can make sure you’re not taking too much on at once. Business lenders also use this ratio to gauge your attractiveness as a borrower, since too much debt may signal that your company isn’t making enough money to finance enough of its own operations.
A healthy debt-to-equity ratio keeps both numbers relatively low, and near one another in value. In other words, the lower the ratio the better. However, debt-to-equity ratios vary by industry and can be sensitive to interest rates.
Calculating a debt-to-equity ratio — an example
Patty wants to take out a loan to purchase a new pastry proofer. But first, she has to figure out how much debt her pagoda has relative to its equity, since this helps lenders determine if she’s able to prove her ability to pay them back. Patty has $250,000 in assets and $190,000 in liabilities. This gives her a debt-to-equity ratio of 1:6, which means she has one dollar of debt for every six dollars of equity. That’s a pretty great position to be in, as it means that most of your company’s money hasn’t come from loans.
Here’s how Patty calculated her debt-to-equity ratio:
Total liabilities (debts) ÷ assets (equity) = debt-to-equity ratio
$190,000 ÷ $250,000 = .76
Just looking at the numbers before doing the math, you can see that Patty’s debts are creeping up on her assets (equity). She’s doing ok, but she might want to pay down some debt and be mindful of her ratio as she moves forward.
4. Operating profit margin
Your operating margin is among the most important, and useful, financial ratios to keep an eye on. It shows the percentage of profit your business generates from operations — prior to subtracting taxes and interest charges.
Your operating margin measures your company’s profitability. It demonstrates how much money is left over from every dollar of revenue you make, minus the cost of goods (COGS) and operating expenses. This figure helps you determine your company’s efficiency — a low percentage means that most of the money you make in sales goes right back into expenses, rather than your bank account.
Be sure that your operating profit margin calculations include the right kinds of expenses. You’ll want to use your operating profit within this formula, since it removes the cost of goods, labor, and other daily business expenses from your total earnings. You’ll also want to exclude certain expenses, such as interest and one-off expenses.
With an operating profit of $200,000 and a total revenue of $150,000, here’s how Patty calculated her operating profit margin.
operating profit ÷ total revenue = operating profit margin
$200,000 ÷ $150,000 = 1.33
This means that Patty earns roughly only 13¢ from her operations once you factor out other costs. This is a margin she’ll want to improve by adjusting pricing, cutting input costs and optimizing her operations.
Get insight into your business’s health
There’s no shortage of metrics out there to help you manage your company’s cash flow. The financial ratios discussed in this article will do the same for you, as long as you know what they mean.
But rather than spend the time calculating these financial ratios manually, simply connect your QuickBooks Online account with your Smansha account. Smansha’s analytics will then comb through your financial data to create an in-depth interactive dashboard containing these ratios and more.
Along with a breakdown of your cash flow metrics, you’ll also receive a proprietary risk score and assessment based on your current QuickBooks Online data.
Get started today and learn more about the factors affecting your cash flow and credit profile.
The information in this article is not financial advice and does not replace the expertise that comes from working with an accountant, bookkeeper or financial professional.
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