Accounting Basics: 4 Financial Ratios You Need to Know
Banks and investors will typically use financial ratios to measure the performance of your business. They may also be used to gain insight on a company’s financial statements. Regardless if you’re a finance whiz, it’s always best to fully understand the financial state of your business. Use these 5 financial ratios to brush up on your accounting knowledge and better utilize your data.
Quick Ratio / Acid Test Ratio
(Cash + Marketable Securities + Net Accounts Receivable) ÷ Current Liabilities = Quick Ratio
The quick ratio, also known as the acid test ratio, measures the liquidity of your business. It will determine whether or not you have enough assets to cover your current liabilities. This is useful if your business has current liabilities such as short-term loans, accounts payable, income and payroll taxes payable, credit card debt, and any other expenses.
The higher your quick ratio, the better position you are in to re-invest cash into your business. A quick ratio of 5.0 means you have $5 in liquid assets to cover each $1.00 you have in liabilities. If your quick ratio is less than 1.0 then your debt is greater than your assets, indicating that it’s probably best to pay off your debts before spending more cash on expanding your business.
Cash Flow to Debt Ratio
(Net Income + Depreciation) ÷ Total Debt = Cash Flow to Debt Ratio
If your small business is having cash flow problems despite making money every month, your business is likely being hindered by debt payments. The cash flow to debt ratio is extremely useful in this case since small business failure is most commonly attributed to cash flow problems.
As the maturity date of your loan closes in on you, the higher your liquidity should be. If your cash flow to debt ratio is less than 1:0 then you’ll need to secure some more funds in order to cover your outstanding debts.
Net Profit Margin
(Total Revenue – Total Expenses) ÷ Total Revenue = Net Profit Margin
Your net profit margin is the percentage of your revenue less operating expenses, taxes, and interest. Nearly every investor will use this ratio as it shows how successful a company is at turning revenue into profits. If your net profit margin begins to dwindle it’s a good idea to tighten up your finances. If you’re spending more money on scaling your business, you can expect this decline. However, if it’s decreasing due to other factors, you should investigate immediately.
A high net profit margin generally means you have found a good price point for your products. The general rule of thumb suggests a profit margin of 10% or higher is good. However, this may vary by industry.
Gross Profit on Net Sales
(Net Sales – Cost of Goods Sold) ÷ Net Sales = Gross Profit on Net Sales
Gross profit on net sales is a good indicator of the ideal price point for the goods and services sold. This ratio calculates whether your average markup covers your expenses and by how much. If your gross profit on net sales is consistently low, then perhaps you’re pricing your products too low or you’re spending too much on production.
It’s a good idea to calculate this on a regular basis, as this can severely affect your bottom line. If you’re suffering from a low gross profit on net sales ratio, it won’t be an overnight fix. Catch the problem early so you don’t cost yourself too much.
You don’t have to be an accounting whiz to stay on top of the financial state of your business. Use these four simple ratios to keep your finances in check.