Ratio analysis enables you to spot trends and measure business performance by providing crucial information that allows you to identify and fix problems before your business is consumed by them.
Though ratio analysis can be complex in nature. There are some basic ratios that you as a small business owner can compute to determine liquidity (does my business have enough liquid to cover expenses),activity(are my business activities generating a good return) and profitability (Is my business making profit margins that I expect). Let’s take a look at these ratios in detail.
1. Liquidity Ratios- measures your ability to meet your short term goals. For example: can you pay all your bills today using your balance sheet. For this answer we will use the quick ratio formula.
Quick Ratio=current assets-inventory-current liabilities;
In this example we will use a service business we’ll ignore inventory
Let’s say your current assets are $10,000 in cash $15,000 in receivables and $8,000 in common stock.
Your liabilities are $30,000 in account payable’s and $8,000 in notes payable’s.
Your target ratio > 1.1
$33,000 = 0.87
Problem: Your current liabilities exceed your current assets.
Solution: Set new terms for your receivables, or find ways to increase your cash flow. See numbers never lie, so with this new information you can implement a strategy that is targeted toward increasing your current assets.
Next let’s look at activity ratios
2. Activity Ratios- measures how efficiently your business resources are being used( average collection period, inventory turnover). For this example we will look at inventory turnover for a discount store i.e..99 store.
Inventory Turnover- measures how many times inventory is turned over in a given year. The higher the turnover ratio the better. Now to compute this ratio you would also need to know what is your industry standard ratio. A quick google search for your industry will provide this information.
Let’s say your cost of goods sold was $150,000 and your inventory on hand is worth $80,000
Example: Discount Store
Industry Standard Ratio 4
Cost of goods sold = $150,000 = 1.9
Problem: Your rate of inventory turn over is much slower than the average in your industry.
Solution: Adding an automated inventory system that tracks how much inventory you have on hand at any given time. So that you are not buying excess inventory. Understanding inventory management is crucial toward increasing your sales and maximizing your profits!
Hopefully at this point you are understanding how ratio analysis can improve and help grow your small business.
Lastly let’s look at profitability
3. Profitability Ratios- are a group of financial ratios that measures returns on sales and investments
Example: A high end boutique who sells high priced goods, and your target profit margin is > 15% sales. Your sales for the year are $350,000. Your net profit after taxes is $60,000
Net profit after taxes = $60,000 = 17.1%
In this example you are above your target profit by 2%! You are making money your business is growing and business is good!
As we saw above; using ratio analysis is a simple, yet effective way to increase business performance and promote business growth.