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As discussed in Key Performance Indicators (KPIs): How to Measure Your Business Success, there are many kinds of key performance indicators and ratios you can use to measure and track your company's success. These can be financial ratios or non-financial ratios and can track everything from liquidity, solvency, profitability, internal employee satisfaction, external customer satisfaction, internal processes, and business development goals. However, too many options can often be overwhelming, and it may be hard to know exactly where to start. Below is a simple list of nine important financial health ratios (along with the financial ratio formulas) that business leaders should track monthly.
These ratios can be added as part of your monthly financial close process. As you begin to track these ratios, the historical trends will start to tell you a story about your business. This will allow you to evaluate the health of your business, both over time and within your industry.
The Current Ratio = Current Assets / Current Liabilities
Are your assets greater than your liabilities? It’s worth doing the math.
You can use the current ratio to help determine your company's financial health. Whether or not you have enough cash, accounts receivable, and inventory on hand to cover your short-term debts, payables, and taxes can be indicative of the health of your company. If your current ratio drops below 1, you may have trouble meeting obligations if the need arises.
But a high current ratio isn’t necessarily better. If it’s too high, you may not be using your current assets as efficiently as you could be.
The sweet spot varies from industry to industry, but, generally, if your current ratio lands between 1.5 and 2, the liquidity of your company is right where it should be.
The Quick Ratio = (Current Assets - Inventory - Prepaid Expenses) / Current Liabilities
The quick ratio is another key financial health ratio you can use to measure your company’s liquidity. Unlike the current ratio, the quick ratio only accounts for assets that can be liquidated quickly, like cash equivalents, short-term investments, and receivables.
Assets that would take longer to turn into cash, like inventory, are left out, providing a more conservative but accurate barometer of the present strength of your company and ability to meet immediate financial obligations.
Receivables Turnover Ratio = Net Credit Sales / Average Accounts Receivable
One way to measure your company’s efficiency and cash flow is to determine how often your accounts receivable are collected from your clients.
With this financial ratio, a higher ratio suggests clients are paying receivables quickly, meaning your company will have enough cash on hand to pay for its operating expenses. Strong credit policies can help increase the strength of the receivables turnover ratio.
However, credit policies that are too tight might deter potential customers from being able to make purchases. It is important to find a balance that allows for reliable cash flow and maximizes potential sales.
Inventory Turnover Ratio = Cost of Goods Sold / Average Value of Inventory
Another important financial health ratio you can use to measure your company’s efficiency is to determine how often your inventory is sold and replaced over a set period of time.
A low ratio of sales to inventory on hand could suggest either weak sales, excess inventory, or both. Either way, the longer your inventory sits on the shelves, the less it’s probably worth. Generally, a high inventory turnover ratio suggests you’re moving inventory well. But because this ratio is a measure of efficiency, it’s important to consider the alternative: Maybe you’re not taking on enough.
The healthy range for an inventory turnover ratio varies widely and should be compared to others within your own industry. We hope that a grocer, for example, would replace produce faster than a boat dealer sells yachts. To judge one against the other would be like comparing apples and, well, yachts.
Debt-to-Equity Ratio = Total Debt / Total Equity
Determining your company’s debt-to-equity ratio can be a good barometer of its financial leverage. Debt-to-equity measures your company’s total liabilities against shareholders’ investments. Aggressive leveraging, for example, will produce a high debt-to-equity ratio.
In order to operate, some industries need more capital on hand than others, so healthy debt-to-equity ratios vary from one industry to the next. If your company’s debt-to-equity is much higher than the industry average, potential investors may view your company as a high-risk choice.
Debt-to-Asset Ratio = Total Debt / Total Assets
A second leverage ratio measures debt against assets. Like debt-to-equity, the higher your debt-to-asset ratio, the greater your company’s leverage. And, once again, if the ratio is significantly higher than the average debt-to-asset ratio in your industry, your company may be viewed as a risky investment.
In addition, significant amounts of debt may indicate that the company is spending significant amounts of cash to pay down interest on that debt. This cash could be better spent on growing and strengthening other areas of the business.
Net Profit Margin = (Net Income / Revenue) * 100
Of every dollar your company earns, how much is translated directly into profit? Determining your net profit margin can answer that, giving you an idea of how profitable your company is. The higher the ratio, the higher your net profit margin.
The net profit margin is expressed as a percentage; therefore, it can be used to compare your business against other businesses of varying sizes. Standard net profit margins vary significantly by industry, so obtaining average ratios for your industry can be helpful for comparison purposes.
It is important to remember that net profit margin can be impacted by one-time events, such as the recent Paycheck Protection Program loans or the Employee Retention Credits. Therefore, it can be helpful to consider multiple profitability ratios.
Gross Profit Margin = [(Net Sales – Cost of Goods Sold) / Net Sales] * 100
Another profitability ratio that removes the impact of one-time events is the gross profit margin. This ratio considers only the direct cost of the goods being sold, and therefore excludes the impact of all selling, general, and administrative costs. The higher the ratio, the higher your gross profit margin.
For this ratio to be an effective tool, it is important to have an appropriate understanding of the direct costs versus the indirect costs within your business.
Return on Equity = Net Income / Total Equity
Shareholders have questions of their own, like "Is my investment being turned into profit?" Your company’s ROE can tell you how profitable your shareholders’ investments are by measuring net profits for the fiscal year against the equity invested. A strong ROE is a clear sign that your company is effectively managing shareholder’s equity.
Is your company healthy? It’s not an easy question to answer, and we are often overloaded with so much information that it's hard to even know where to start. But our favorite nine financial health ratios should provide some insight into the relative health of your company as compared to others in your industry, as well as provide some data points to begin tracking your company's progress over time.
Want more insight into the relative health of your company? Need industry reports for comparative purposes? Not sure about the difference between direct and indirect costs and how they are impacting your bottom line? Still not sure which important financial ratios are the best to use for your business? Delap has many experts who would love to help you better understand how to use these financial health ratios and evaluate the strength of your business.