Analyzing business financial ratios allows lenders to see how your business is doing and compare it to other businesses. Ratio analysis also is a useful tool for business owners. Some basic ratio analysis helps you to assess how healthy your business is, diagnose potential problems, and see if your business is doing better or worse over time. The first step is understanding how to calculate different ratios and interpret the results.
Current Ratio
The current ratio measures whether or not your business has enough resources to pay its bills over the next 12 months.
Note
Current ratio = Current assets/Current liabilities
Current assets are a category of assets on the balance sheet that represents cash and assets that are expected to be converted into cash within one year. Current liabilities are a category of liabilities on the balance sheet that represent financial obligations that are expected to be settled within one year.
Suppose a business has $8,472 in current assets and $7,200 in current liabilities. Then the current ratio is $8,472/$7200 = 1.18:1.
So for this business, the current ratio gives a clean bill of health. For every dollar in current liabilities, there is $1.18 in current assets, and a current ratio greater than 1.0 generally is good. If you are comparing your current ratio from year to year and it seems abnormally high, you may be carrying too much inventory.
Total Debt Ratio
Total debt ratio does exactly what the name suggests: It shows how much your business is in debt. Understanding this ratio is an excellent way to check your business’s long-term solvency.
Note
Total debt ratio = Total debt/Total assets
You can take these numbers from your balance sheet and plug them in. For instance, a business with $22,375 in total assets and $25,000 in total debt would have a total debt ratio of:
$25,000/$22,375 = 1.11:1
This business, then, is $1.11 in debt for every dollar of assets. So for this business, the total debt ratio tells us that this business is not in good health and may become ill. For good health, the total debt ratio should be 1.0 or less.
The lower the debt ratio, the less total debt the business has in comparison to its asset base. On the other hand, businesses with high total debt ratios are in danger of becoming insolvent or going bankrupt. Lenders pay especially close attention to this ratio.
Profit Margin
How much net profit your business is producing can be determined by calculating your profit margin.
Note
Profit margin = Net income/Gross sales
If a business’s gross sales are $180,980 and its net income is $42,325, its profit margin is:
$42,325 / $180,980 = 23.4%
So for every dollar in gross sales, this business is generating a little more than 23 cents net profit. Obviously, the higher the profit margin, the better off the business, but the profit margin also is useful to measure how a business is performing over time.
At a glance, you can see whether your business’s net profit has increased, stayed the same, or decreased over last year. And if it’s decreased, you’ll know to take steps to cure the problem, such as better controlling your expenses.
Applying the Ratios
Imagine the ratios in the examples above belonging to a single business, and you can see how just calculating these three ratios can provide a quick health check for your business. The business in the example isn’t at death’s door yet, but it is ailing. While the profit margin and current assets ratio are robust, the total debt ratio shows that the business is carrying too much debt, which will interfere with cash flow if it hasn’t already.
Debt-to-Equity Ratio
If your business is incorporated, the debt-to-equity ratio is an important measure of the total amount of debt (current and long term liabilities) carried by the business vs. the amount invested by the shareholders.
Note
Total debt ratio = Total debt/Total assets
If a business's total liabilities are $500,000 and the shareholder's equity is $600,000 the debt-to-equity is:
$500,000 / $600,000 = 0.83
In other words, the portion of assets provided by the shareholders is greater than that provided by creditors, which typically is a good sign.
If your business needs debt or equity financing, the debt-to-equity ratio will be closely scrutinized by lenders or investors. The higher the ratio, the higher the risk carried by the business.
Debt-to-equity ratios are benchmarked by industry. Capital-intensive industries such as transportation and utilities tend to have higher ratios (2.0 or more) while industries such as insurance carriers usually have ratios lower than 0.5.
