Monitoring the financial performance of your business is key to understanding its overall health and uncovering trends. It’s not enough to read and maintain your financial statements. You also need to know how to interpret the numbers so they tell a full story. Financial ratios can help you do just that.
Financial ratios are calculations that reveal the relationships between different values of your company’s financial statements. They simplify unwieldy numbers and enable you to compare them to industry or regional averages to see where you stand. They generally fall into four categories: liquidity, solvency, profitability, and operating efficiency.
Liquidity ratios measure the amount of cash (and assets that can be easily converted into cash) to meet short term financial commitments. A fundamental ratio is the current ratio:
Current Ratio = Current Assets ÷ Current Liabilities
Examples of current assets are cash, short-term investments, pre-paid expenses, accounts receivables, and inventory. Current liabilities can be credit card debt, accounts payable, bank operating credit, accrued expenses and tax payable. The rule of thumb is to have more assets than liabilities with a ratio of about 2:1.
If this isn’t the case, then there are actions you can take to improve this number. Increase your assets by staying on top of invoices. Use this worksheet to identify ways your business might be “bleeding cash.” Decreasing overhead is also an option. Get creative and decrease your monthly rent through colocation.
Solvency ratios shed light on your ability to meet debt obligations on an ongoing basis, while sustaining operations indefinitely. You can calculate this by using the debt to equity ratio:
Debt to Equity = Long Term Debt ÷ Equity
This means that your company is financed by shareholders rather than creditors. The lower the number the better. Check out this article’s section on equity financing for a simple overview of the concept. If you decide to improve this number by increasing equity, here are five questions to ask a potential investor in your business. You can also try building equity through crowdfunding, which allows you to raise money from a community of potential investors via an online forum.
It goes without saying that profitability is the most important indicator of success. Only you will have a sense of a healthy profit margin for your business. Net Profit Margin is the best indicator of financial health and long-term viability.
Net Profit Margin = Net Income or Profits ÷ Total Revenue
You can improve profitability by increasing Customer Lifetime Value (CLV) and getting creative with your customer engagement program. Consider crafting a winning customer loyalty program or finding ways to encourage recurring purchases.
Also dig deeper and evaluate the pricing of your products. Have you accurately accounted for the cost of your expenses in each category? If your analysis leads to the decision of raising your prices, be sure to devise a plan to keep your customers happy despite the price increase.
Operating ratio evaluates the efficiency of your company’s core business activities by comparing operating expenses to net sales:
Operating Ratio = Operating Expense ÷ Net Sales
Your operating expense is the total of all expenses, not including taxes and interest payments. Monitor it over time and notice when it increases. That’s a sign of inefficiency. Operating expenses are increasing or net sales are decreasing. If you see this happening look for ways to streamline your business processes or make better use of your assets.
Clover is built with hardware and software that will help you run your business more efficiently. Now is the time to break down each moment in the day, vigorously identify inefficient practices and find ways to end them. For example, restaurants can find ways to streamline order deliveries or use a Clover handheld device to take payments at the table.
Other Insights To Consider
While financial ratios are a common way to monitor your business they are not the only way. It’s up to you to identify the right combination of numbers that will provide you with the right information that will support sound decisions. If you’re still feeling intimidated by the idea of crunching numbers, then try Clover Insights to benchmark your performance against similar businesses.
Clover is sold by leading U.S. banks including Bank of America, BBVA, Citi, PNC, Sun Trust and Wells Fargo. You’ll also find Clover at our trusted partners including Ignite Payments, Restaurant Depot, and Sam’s Club. For more information, visit us at clover.com.