What Is Financial Ratio Analysis? A Small Business Guide

Financial ratios depict relationships between accounts and line items in your financial statements, such as assets compared to liabilities or total debt compared to owners’ equity. Financial ratio analysis is the process of examining those relationships for insights into your business’ liquidity, profitability, efficiency, and solvency and how it’s doing against industry standards and benchmarks.

There are many types of financial ratios, generally focused on measuring risk or return. As a business owner, interpreting these ratios is an accounting basic to assess if your business is going down the right path. Small business accounting software can help produce financial statements with a few clicks. Check our list of the best small business accounting software for generating the basic financial statements.

Financial Ratios at a Glance

Measures of Risk

The first category of financial ratios pertain to the risks of doing business. All businesses are at risk of failure, bankruptcy, and closure. By understanding liquidity and solvency ratios, you can gain insight into if your business can stay afloat in the foreseeable future.

Short-term Liquidity Ratios

Short-term liquidity refers to the ability of a company to convert short-term assets to cash to pay its short-term liabilities. To measure short-term liquidity, you can use the following ratios:

• Current ratio: A ratio above 1.0 indicates that there are enough current assets to cover current liabilities. However, it may also indicate poor cash management, such as keeping too much or too little cash.

• Quick ratio/acid-test ratio: A low acid-test ratio isn’t necessarily indicative of illiquidity. It’s common for businesses with high inventory values, such as retail and merchandising businesses since the value of inventory isn’t included in the numerator.

• Cash ratio: A high cash ratio is a good indication of enough cash reserves. However, it may show signs of poor cash management if the cash ratio is too high.

Solvency or Leverage Ratios

Solvency is the ability of the company to pay off its obligations as they come due. Lenders are very particular about your solvency because they want to assess your ability to pay. Here’s how we interpret solvency ratios:

• Debt ratio: A low debt ratio indicates that your business isn’t swimming in debt, a positive trait when applying for a loan. Meanwhile, a high debt ratio is a red flag for lenders, unless it’s normal in your industry to have high debt ratios.

• D/E ratio: A lower D/E ratio means that the business is funded by capital, not by debt. It’s also a sign that the business has adequate funds from the owners or shareholders.

• TIE: A high TIE ratio indicates that the company can settle contractual interest payments on time. It also means that the earnings before interest and taxes (EBIT) are enough to cover interest expense.

• EBITDA coverage: A higher EBITDA coverage is an indication of the sufficiency of earnings before taxes, depreciation, and amortization in covering fixed payments, such as leases, loans, and interest. If the EBITDA coverage is low, it may raise a red flag regarding the company’s ability to keep up with fixed payments.

• Debt coverage: A high debt coverage ratio shows that the company’s income is enough to pay debts. However, the use of accrual accounting may distort debt coverage since revenue recognized may not represent cash available to pay liabilities.

• Asset coverage: In case of liquidation, a high asset coverage means that the value of assets is enough to cover the debts. A major caution here is that asset values may not reflect current fair market values.

Aside from these ratios, you can also consider the net working capital in assessing liquidity. The net working capital can indicate your ability to meet current financial obligations and allocate enough resources to meet operational requirements.

If you have a low working capital, it might affect your operations by not having cash to take advantage of unexpected opportunities, such as early payment discounts. You can increase your working capital through a short-term loan. If you want to know more about this, we have an article on how to get a small business loan.

Measures of Return

If there’s a risk, there should be a return. In the previous section, we discussed the ratios that measure the risks of doing business. In this section, we’ll discuss the measures of returns that should balance out with the level of risk.

Performance or Efficiency Ratios

Performance ratios depict the company’s ability to convert resources into revenues. More specifically, it’s also how efficiently the company uses its assets to generate revenues. The ultimate goal here is to generate the highest return with the least resource consumption.

• Inventory turnover: A high inventory turnover indicates that inventories are sold faster. It may indicate high demand and high sales. However, a low turnover may reveal poor marketing strategies that resulted in lower sales or the purchase and holding of too much inventory.

• Average age of inventory: A short average age of inventory means that inventories are sold faster and stored for shorter periods of time. In contrast, a longer average age of inventory may reveal signs of obsolete inventory or declining sales.

• A/R turnover: A lower A/R turnover indicates that the company is efficient and effective in collecting receivables from customers. Meanwhile, a higher A/R turnover may reveal signs of poor credit collection or the existence of worthless accounts.

• Average age of receivables (or average collection period): Shorter collection periods indicate that you can collect receivables faster, which is good. However, a very low collection period may indicate very strict credit-granting policies that are inhibiting sales to credit-worthy customers. However, longer collection periods may indicate slow collection or too relaxed credit-granting policies.

• A/P turnover: A high A/P turnover indicates that you’re paying trade payables as early as possible. In the extreme, a high A/P turnover could mean that you’re not taking advantage of your vendor’s grace period for payments. A low A/P turnover may indicate short-term illiquidity or an inability to pay your bills.

• Days payable outstanding: The days payable outstanding―also called average payment period―should be less than or equal to your company’s expected payment period. A longer payment period may indicate poor cash management or illiquidity since the company can’t pay obligations on time.

• Fixed Asset turnover: The asset turnover varies across industries. For retailers and merchandisers, an asset turnover ratio of 2.5 or more is considered good. However, service-based companies might have lower values.

Profitability Ratios

People enter into a business because they want to earn profits. That’s why profitability ratios are paired with performance ratios. It’s rare to see poor performance ratios and excellent profitability or vice-versa. Often, these two groups of ratios have a cause-and-effect relationship.

• Gross margin: Efficiency may translate to a high gross margin since the COGS is low.

• Operating profit margin: A high operating profit margin also results from efficiency since operating costs are low or maintained at a low level.

• Profit margin: The profit margin can be used to determine the overall profitability of the company. It can also be used as a figure in determining the desired return on investment.

• ROA: A high ROA indicates high profitability. It also shows that the company is efficiently using the assets and resources in generating income.

• ROE: A high ROE encourages stockholders to invest more in the company or to attract other people to invest in the company.

The DuPont Model

Another helpful model in assessing profitability is the DuPont model. This model is primarily a measure of return but it can also be a measure of risk. The DuPont formula is similar to the return on equity, but it considers the company’s financial leverage, profit potential, and asset utilization. Unlike the return on equity, the DuPont model includes financial leverage by including an equity multiplier in the formula.

How Does Financial Ratio Analysis Work?

The first step in performing a financial ratio analysis is getting the latest copy of the financial statements. If you’re using QuickBooks Online, you can quickly generate an income statement and balance sheet. Then, you have to create a spreadsheet where you can enter the ratio formula and the data. Once you’re done entering the values, all you need to do is analyze the amounts and interpret them concerning the company’s performance.

You should do this every month to watch for important changes in your ratios. If you want professional feedback, you can consider hiring a certified public accountant (CPA) or chief financial officer (CFO) consultant to interpret the figures for you.

Uses of Ratio Analysis

Here are some of the major uses of ratio analysis in small business management:

1. Decision-making: The primary purpose of ratio analysis is for decision-making. If you’re in the middle of a big business decision, ratios can show if your business’ financial framework can withstand or afford significant business changes. Investors should use ratio analysis to assess if it’s worth investing in the company.
2. Performance evaluation: The secondary purpose of ratio analysis is to evaluate business performance. Ratios can show possible or existing problems in your business when there are significant deviations from the norm. For example, if inventory turnover in the current year increased to 67 days, while the five-year average is only 41 days, then something significant has changed and warrants further investigation. Significant variances in ratios are worth investigating to spot operational bottlenecks or problems.
3. Small business loan application: Financial statements are one of the small business loan requirements when applying for a loan. Lenders will conduct ratio analysis to understand your business performance and liquidity. They also compare your ratios with industry averages to evaluate your business performance and liquidity in context with other companies in the same industry.
4. Company valuation: Financial ratio analysis is a step in company valuation or fundamental equity analysis. Company valuation methods are helpful when buying or selling businesses and common for venture capitalists.

Caveats of Financial Ratio Analysis

Financial ratios don’t show the full picture of your company’s performance. Using it has some caveats so you have to proceed with caution when interpreting the numbers.

• Use of historical information: Financial statements only depict financial position and financial performance based on historical results which isn’t necessarily an indicator of the future. Moreover, assets in the balance sheet are most reported at historical costs, not current fair market value.
• Absence of human resources: The skills, aptitudes, and talent of your employees are never quantified in the financial statements, although they have a major impact on your efficiency and profitability.
• Disregard of inflation and other economic indicators: Inflation could overstate or understate asset valuation.
• Changes in accounting estimates and policies: A change in accounting estimate or policy may affect the comparability of financial statements unless changes are done retrospectively by adjusting previous earnings.
• Use of earnings management and creative accounting: Ratio analysis is affected by the use of questionable accounting practices, such as overstating earnings in a period or smoothing reported earnings across periods. Ratios can produce misleading information if the financial statements aren’t faithfully presented.

Bottom Line

Financial ratios can help companies assess their overall performance. However, ratios alone don’t show the full picture. It can be sometimes misleading due to controllable and uncontrollable factors affecting the business. But as a small business owner, knowing how to use ratio analysis can help you monitor your business and make guided decisions.