At a Glance
Main Takeaway
Financial ratios are an essential tool that businesses can use to assess overall growth and performance. Whether your business is looking to improve its profitability or sell to an investor in the next few years, tracking your financial metrics is critical in understanding where you are underperforming and where to make operational changes.
Next Step
Explore common financial ratios and a few not-so-common financial KPIs that you can track to reach desired company performance and financial goals.
What are Financial Ratios?
Financial ratios are comparisons of two or more financial metrics that businesses and organizations use to assess their economic performance. Financial ratios are based on accounting practices, and the financial data is typically taken from business financial statements.
Companies perform ratio analysis to obtain insights from these financial metrics. Ratio analysis allows businesses to assess their operation’s efficiency, profitability, and liquidity to evaluate their processes.
Why are Financial Ratios Vital to Your Business?
Before you start tracking your financial KPIs, it is helpful to understand why financial ratios are important to your company’s success. While calculating and publishing financial reports is essential to running your organization, examining your financial ratios provides you with actionable insights.
Without comparing different metrics, you cannot see how you have improved over time or understand the impact of a particular employee or operational element on your company’s profitability.
One of the most significant benefits of financial ratio analysis is comparing your performance over time. It also allows you to compare different KPIs to judge financial performance, liquidity, efficiency, and solvency.
If you monitor uncommon financial ratios, such as sales per square foot, you can measure how well you use your space to save money in non-traditional areas.
Financial ratios give you an expanded view of business performance and allow for actionable insights that you can use to become more profitable. They also help you understand how you are performing against the industry average and project its future performance.
Common Financial Ratios
Most businesses perform analysis using the following typical business financial ratios:
Working Capital Ratio
The working capital ratio helps you access the liquidity of your company. The ratio measures your business’ current liabilities and assets to determine how much cash you can access to pay short-term expenses.
Divide your current assets by your current liabilities to determine your working capital. If your ratio is one or lower, you may struggle to meet your short-term liabilities. A ratio of two or above indicates you are highly liquid.
Businesses with high liquidity should consult with a value acceleration firm to determine if reinvesting some of those cash assets can help grow the company.
Quick Ratio
The quick ratio, also called the acid test, helps measure liquidity. To calculate your quick ratio, perform the following equation:
Current assets – inventory and prepaid expenses ÷ current liabilities = quick ratio.
Similar to the working capital ratio, if your ratio is one or less, you may need to change operational factors to gain more liquidity. For example, a company has $5 million in current assets, $3 million in inventory and prepaid expenses, and $1 million in liabilities. $5 million – $3 million = $2 million. $2 million ÷ $1 million = 2. This company has sufficient liquidity.
Debt-to-Equity
The debt-to-equity (D/E) ratio lets you see if your company has borrowed too much money. You may have obtained finance from investors or financial institutions to start your business. However, if you continue borrowing or have not made enough profit to pay down your debt, you will carry a high D/E ratio which can cause problems for your company.
To determine your D/E ratio, divide your company’s total liabilities by your private equity. A low D/E ratio varies by industry and your company’s specific goals; however, a ratio of one or less is considered favorable, while anything higher than a two indicates risky business financials.
Return on Equity (ROE)
Typically, the return on equity ratio (ROE) measures profitability and a company’s effectiveness in using shareholder money to increase profits. ROE can refer to the same concept with private investors in the private business world.
Calculate your net income and divide it by your equity to determine your ROE. If you have been using investor funds appropriately, you should see a high ROE, indicating that shareholders of your company are seeing a high return on their investment.
Most private companies should aim for a 40% ROE; however, it may take several years to achieve this goal.
Not So Common Financial Ratios
While most prudent business owners use common financial ratios to assess their business performance, you may also consider analyzing some not-so-common KPIs. These can include the 8 drivers of company value as indicated by Windes’ value acceleration practice or other elements listed below.
Employees Per Square Foot
To assess the efficiency of your commercial space, divide the square feet in your office by the total number of employees. This number can tell you if you use the space wisely or waste money on the square footage you do not need.
Net Promoter Score
The promoters and detractors ratio can indicate how fast your business may grow. Ask customers or clients to rate the likeliness of referring your business to another on a one to ten scale. Nines and tens are promoters; zero through six are detractors.
Determine the percentage of detractors and supporters, then deduct the detractor from supporters. If your net promoter score is between 10% to 15%, you will likely grow quickly.
Sales Per Square Foot
If you own a retail store, calculating sales per square foot can help you stay on track with profitability. Divide your annual sales per square foot of your retail space to obtain a number. Compare your dollar sales per square foot to industry standards to see how you measure up.
Customers Per Account Manager
If your business is in the financial sector, keep track of the number of clients under one account manager. An account manager with too many clients may not manage them effectively or provide attentive service. Settle on a number that helps you meet your revenue goals but does not sacrifice service levels.
Revenue Per Employee
Calculate your revenue per employee to determine if you have too many workers or not enough. Divide your annual revenue by the number of people employed by your company. Benchmarks vary by industry, but a lower revenue per employee may suggest you need to consider a different organizational structure.
Prospects Per Visitor
Consider tracking how many leads and conversions you gain when someone visits your company. This can include online traffic or people who walk in your brick-and-mortar business.
Accelerate Your Business With Windes
Work with Windes to accelerate and grow your company or achieve maximum valuation before selling to a private buyer. We can help you develop strategies to avoid common entrepreneurial mistakes and focus on value drivers to grow your business.
We proudly service businesses in Los Angeles, Long Beach, and Orange County in California.
Contact Windes today at 844.494.6337 or info@windes.com to learn how we can help you identify common and not-so-common financial ratios and KPIs to track and maximize your business’ profitability.
