Financial ratios are calculations that relate one item in your financial statements to another. They can be valuable tools for assessing your business’s financial well-being.
Getting the most out of financial ratios
In most cases, the usefulness of financial ratios depends on a clear understanding of the relationship between the numbers used and their implications for your day-to-day business.
That’s why, unless you have a strong understanding of accounting principles, you may want to ask your accountant or bookkeeper to help you interpret your financial statements and financial ratios.
Current ratio
The current ratio = current assets / current liabilities.
This ratio is a measure of liquidity – or the availability of cash (or assets that can be converted easily into cash) to run your business and meet its short-term obligations.
Liquidity describes your business’s ability to meet current commitments, such as:
- Paying supplier invoices.
- Making upcoming loan payments.
Generally, the higher your business’s current ratio, the more confident you can be of its ability to pay its immediate obligations. A current ratio of less than 1:1 may mean your business doesn’t have sufficient resources to meet its commitments in the near future and needs additional financing.
Return on equity ratio
The return on equity ratio = net profit / total equity.
This ratio measures the return your business generates for owners who’ve invested in it. By measuring the percentage return to owners on their cash equity contributions, it’s a general indicator of how efficiently your business makes use of its owners’ money.
Gross profit margin
The gross profit margin = gross profit / sales
For non-service businesses, your gross profit margin captures the relationship between your sales and your cost of goods sold – the cost to your business that directly relates to purchasing or manufacturing your products. Your cost of goods sold (COGS) doesn’t include general administration or other indirect costs.
Your gross profit margin is the percentage of every dollar in sales you have left over after paying direct costs for manufacturing or acquiring goods sold, to cover all remaining expenses and taxes.
A low gross profit margin may indicate that:
- Your business is selling goods at too low a price.
- Demand for your products is weak.
- Direct materials, direct labor, or manufacturing overhead costs can be better controlled.
Net profit margin
The net profit margin = net profit / sales
The net profit margin is the percentage of each dollar of sales that remains after all expenses have been deducted. When compared to your gross profit margin, net profit margin can be an important indication of how your business manages its expenses.
Debt to equity ratio
The debt to equity ratio = total liabilities / total equity
The debt to equity ratio describes the relationship between liabilities and equity. It compares the level of financing provided by creditors like suppliers and banks to the amount that owners have invested in your business.