Interpreting financial ratios requires making comparisons across time. A single ratio calculation won’t provide much insight unless compared against data from prior periods or competitors.
Small business owners can use appropriate ratios to assess their own performance and make strategic adjustments for growth, but it’s equally important that these ratios align with your unique business model requirements.
Profitability Ratio
Profitability ratios provide valuable insights into your company’s ability to make money. They can help identify profitable products or services and track their performance over time, as well as pinpoint areas that need improvement for increased profitability. In addition, profitability ratios provide benchmark assessments relating to industry benchmarks.
Profitability metrics such as gross profit, operating margin and net income provide unique views into the success of your company’s finances. Gross profit measures how much of the sales remain after paying the cost of goods sold; operating margin reveals how efficiently your costs and operational efficiency are being managed; net income measures the portion of sales remaining after deducting all expenses and taxes have been applied.
There are two primary profitability ratios, margin and return ratios. Margin ratios measure how efficiently sales can convert to profits while return ratios compare returns on assets to capital invested in a business.
Liquidity Ratio
Liquidity ratios are used by creditors and lenders to assess a business’s ability to pay its debts and obligations on time. They compare current assets – such as cash, cash equivalents, accounts receivable and inventory – with current liabilities in order to determine its liquidity ratio.
Liquidity measures can help your company spot potential issues before they worsen, such as days sales outstanding that linger too long, which may indicate the need to find ways to get clients paying faster.
Liquidity ratios can help you compare companies in a specific industry. Industry averages can be found from various sources such as Statistics Canada or financial data vendors; alternatively you can calculate them yourself using information from your balance sheet, profit and loss statement and cash flow statement with standard spreadsheet software such as Xero; or you may purchase industry-standard ratios online databases or your BDC business advisor for a fee.
Cash Flow Ratio
Businesses often utilize this metric as it shows how effectively their debt payments can be met through operating cash flow. Business owners should use it before taking major decisions such as entering new markets or investing in major assets.
Comparing financial ratios over time provides context and highlights trends, while it is also crucial to take account of industry norms and benchmarks when assessing performance.
Ratios are highly useful profit tools that offer standardized assessments of profitability, liquidity, solvency and efficiency. Unfortunately, however, ratio analysis isn’t without its shortcomings; Artsyl docAlpha can enhance your financial ratio analysis with intelligent document processing that streamlines data extraction from financial statements for more accurate results and deeper insights. Discover ways Artsyl can automate this process so your team can devote its time more strategically for decision-making purposes.
Return on Investment
Return on Investment (ROI) measures how much profit your business is making relative to how much was invested into it, providing an essential indicator of its profitability and competitiveness. Calculations can be complex when comparing results across periods or companies, which is why using outside financial assistance such as part-time CFO services may help your interpret and leverage this valuable tool more efficiently.
Internal Targets
Your current ratios provide a basis for setting internal goals that reflect where you want your company to head over time, such as increasing profit margin ratio or liquidity or improving debt service coverage ratio. Furthermore, lenders often enforce benchmarks and failing to meet them can result in loan recall or higher interest rates for your business.
ROI fails to take account of time value of money; hence an investment with a lower ROI may still prove cost-effective in the long run. For instance, green energy projects might have lower ROI due to longer payback periods and should still be taken seriously as potential investments.