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Five Key Financial Ratios to Empower Your Small Business
Most business owners understand the importance of monitoring their company's finances to maintain a financially sound operation. However, fewer know the value of using financial ratios to gain a deeper understanding of their company's financial statements and to assess its overall health.
What Are Financial Ratios?
Ratio analysis provides insight into a business’s liquidity, profitability, and efficiency by analyzing financial statements such as balance sheets and income statements. These ratios take raw financial data and turn them into actionable information, such as identifying how profitable the business is or highlighting potential risk areas. Financial ratios offer a snapshot of your business's health, but to get the most value, it’s best to track trends over time rather than relying on a single snapshot.
What Is a Net Profit Margin?
The net profit margin shows how much of a company's revenue remains as profit after all expenses are deducted. This ratio helps you understand how efficiently the company controls its costs. A high net profit margin indicates that a business is effectively managing its expenses. The formula for calculating net profit margin is:
Net profit ÷ Sales x 100
What Is a Gross Profit Margin?
The gross profit margin reflects how much money is left after covering the cost of producing goods or services. While net profit margin includes all expenses, gross profit margin focuses on production costs. The formula for gross profit margin is:
(Net sales - Cost of goods or services sold) ÷ Net sales x 100
What Is an Operating Profit Margin?
The operating profit margin measures how much profit a business generates from its core activities after covering operating expenses like wages and materials, but before interest and taxes. This ratio is particularly useful for understanding profitability from main business activities. The formula for operating profit margin is:
(Gross profit - Operating expenses) ÷ Revenue x 100
What Is the Working Capital Ratio (or Current Ratio)?
The working capital ratio (also called the current ratio) assesses whether a business can meet its short-term obligations. A ratio of 1 or higher indicates that a business has more assets than liabilities, meaning it can cover its debts. The formula for the working capital ratio is:
Current assets ÷ Current liabilities
What Is Inventory Turnover?
This ratio is critical for businesses that manage stock, as it shows how often inventory is sold and replaced within a given period. It helps businesses maintain appropriate stock levels and avoid either overstocking (leading to wasted capital) or understocking (resulting in missed sales). The formula for inventory turnover is:
Cost of goods sold ÷ Average inventory
The Bottom Line
These five financial ratios provide a clear picture of your business's financial health. By regularly monitoring these ratios, you'll be in a stronger position to make informed short-term and long-term decisions that support the growth and sustainability of your business.
