Important Financial Ratios for Businesses

The most important financial ratios and how to use them to make informed decisions

Small business leaders and decision-makers often strive to enhance their financial analysis and decision-making capabilities to manage progress toward their goals. But it can be difficult to quantify financial factors, especially when you don't have ratios that align with the metrics you're examining. For instance, when analyzing profitability, you would need one ratio to assess profitability that includes the cost of materials and labor (gross profit margin). But you'd need a different ratio to analyze profit after considering taxes and interest earned on investments (net profit margin).

This is where a general knowledge of financial ratios can make a big difference. By understanding which ones you need to pay attention to, you can calculate and derive insights from efficiency, profitability, and liquidity ratios—as well as create more informative reports for other decision-makers.

What are financial ratios, and why are they important for evaluating a business?

Financial ratios refer to metrics you can leverage to assess the financial strength of your business. They're designed to make it easier to compare a variety of variables, such as your cost of goods sold (COGS), debt, income, inventory expenses, and more—many of which come from financial statements.

One of the most common financial ratios, profit margin, is an excellent example. Here's the formula you use to calculate profit margin:

From an analytical perspective, profit margin tells you how efficiently your business generates a profit. Because the numerator is "net income," the ratio factors in business expenses, such as the cost of materials and advertising. Therefore, if your expenses are low, then your net income will be higher, and when it gets divided by revenue, the resulting ratio will also be higher. Therefore, a higher profit margin indicates more efficient use of your financial resources.

In other words, profit margin tells you whether or not you're spending too much when compared to the income you're generating. This particular financial ratio becomes a valuable tool for determining profit levels. If your business is generating a profit, that's great, but if your profit margin is too low, you may need to cut back on some of your overhead expenses to maintain long-term solvency.

In this way, financial ratios provide insights that help you assess the underlying health of your business. For small-to-midsize business (SMB) owners, financial ratios make generating meaningful metrics for business performance quantification easier. This solves a key business problem: Some companies may only look at basic numbers without putting them into perspective. But using financial ratios, you compare multiple business factors, such as your full range of expenses, cost of debt, and the value of your assets, uncovering a more accurate view of your organization's performance.

It's easy to confuse financial ratios with key performance indicators (KPIs), but the two are unique. KPIs are measurements consisting of a single metric, such as revenue and earnings before interest and taxes (EBIT). Ratios are formed when you compare two KPIs by making one a numerator and the other a denominator. However, KPIs are valuable to CEOs because they can help identify which financial ratios are the most useful.^[1]

For example, suppose you're a CFO for a company looking to land a merger deal within the next three years. To make your company more attractive for a merger, you set a KPI of reducing your net debt. In that way, a firm you merge with won't be scared off by debt they may have to assume if they merge with you. Since this is a valuable KPI, you may want to use the debt-to-income ratio. This ratio can help you set goals for reducing debt. However, it can also make it easier to determine when to stop spending cash to reduce debt and maintain your current debt levels.

Common financial ratios and how to use them

Using financial ratios to evaluate your business's performance starts with choosing the type you need. What are the most important financial ratios? Some of the most useful include efficiency, leverage, profitability, and liquidity ratios. Here's an explanation of the most important financial ratios to analyze a company's financial performance.

Efficiency ratios

With efficiency ratios, you can measure how well your company uses its people, materials, and other assets to stimulate revenue. They're especially useful when you want to understand whether your operations are efficient or wasteful—and to what degree.

Take the inventory turnover ratio as an example. This assesses how efficiently you manage inventory by examining how often you sell inventory and replace it over a certain period. You calculate it using your cost of goods sold (COGS) like this:

In other words, if a company has a COGS of $700,000 and an average inventory value of $100,000 over a quarter, the inventory ratio would be 7 ($700,000/$100,000). Now, suppose the company's inventory turnover ratio for the following quarter dropped because the average inventory rose to $150,000. $700,000 divided by $150,000 equals 4.67. This lower ratio may indicate that the company is either overstocking its inventory or overestimating the speed at which it could sell its products.

Leverage ratios

You can use leverage ratios to compare how much debt you have to your equity and/or assets. This makes leverage ratios valuable for assessing your organization's ability to make payments on its debt.

Using leverage ratios to analyze how well you can meet your debt obligations can be essential to your financing plan. It can also prevent getting denied financing. This is important because, according to Capterra's Financing Survey*, over the last two years, 56% of businesses have been denied financing at least more than once due to a lack of collateral, poor cash flow, or high (or too low) credit utilization.

To reduce the chances of getting denied a loan, you can use a leverage ratio such as debt-to-equity. This shows how much equity your company generates for each dollar of debt. You calculate it using this formula:

For example, suppose your company has $200,000 of debt and $400,000 worth of shareholder equity. That would give you a debt-to-equity ratio of 0.5. This means that your company has $0.50 of debt for every dollar of equity.

If your debt-to-equity ratio were to drop the following year, many would see this as a good sign—you don't need as much debt to generate equity.

Profitability ratios

A profitability ratio tells you how well you can earn profits relative to your assets, equity, or revenue. This helps assess the efficiency with which you generate profits.

The profitability ratio of return on investment (ROI) is yet another one of the most important financial ratios. ROI gauges the profitability of an investment in relation to how much it costs. You calculate it using this formula:

For example, suppose your company sells organic vegetables to restaurants. You have to choose between stocking broccoli or cauliflower. While both of them sell for an average of $3 per pound in your local target market, you have to ship cauliflower from farther away. Therefore, after factoring in shipping, your company's total cost of cauliflower is $2 per pound, while broccoli costs $1.50 per pound.

The ROI ratio for broccoli would be $3/$1.5 = 2.0

The ROI ratio for cauliflower would be $3/$2 = 1.5

Considering broccoli has a higher ROI ratio, you may choose to stock that instead of cauliflower. Or you may choose to stock both but purchase more broccoli than cauliflower to maximize your overall ROI.

Liquidity ratios

Liquidity ratios measure how well you're able to cover your liabilities using your assets, if necessary. A higher ratio indicates that you have adequate assets because if you had to liquidate them, you'd be able to cover your debt obligations.

The current ratio is a good example. You calculate it using the following formula:

To illustrate, let's say your company has $400,000 worth of assets, and your liabilities amount to $200,000. This means your current ratio would be 2.0. If the ratio were to drop to 1.5 the following year, this may indicate that you're assuming too much debt. You could then use this analysis to boost the efficiency with which you use your resources so you don't have to borrow so much money to remain solvent.

How to use financial ratios to make informed business decisions

The process of using financial ratios to inform your business decisions involves a series of steps:

1. Understand the financial ratios that apply to your business. For example, if you're in the retail or manufacturing sector, the inventory turnover ratio would be useful. However, if you run a consultancy service, inventory turnover may not be as useful.

2. Analyze your ratios over time. All of your ratio analysis should involve a delta factor, which takes into account how they change. Even if you use software to automatically calculate your ratios in real time, your analysis should involve checking progress over a year, quarter, month, or another timeframe.

3. Interpret your ratios using multiple contexts. Your ratios can't be simply "good" or "bad" because they're higher or lower. You need to use contextual analysis, which requires looking at your numbers from multiple perspectives. For instance, you could compare your figures to industry averages, past financial performance, and future goals.

4. Acknowledge what your ratios tell you about your strengths and weaknesses. For example, if your liquidity ratios are low, you may need to improve sales to support cash flow. Or, if your profitability ratios are low, you might need to reduce your overhead spending.

5. Periodically meet to discuss opportunities for improvement. Financial ratios highlight problem areas, but the only way to leverage this intel is to review your numbers periodically. This may mean meeting every month—or more frequently—to discuss progress and make adjustments.

Tools and technologies to help you use financial ratios

Embracing technology as you start using financial ratios positions you to automatically generate ratios for faster, more accurate business decisions. Using technological tools in financial analysis has been on the rise. For instance, a Gartner study reveals that by 2027, 90% of descriptive ("what happened") and diagnostic ("how or why it happened") analytics in finance will be fully automated.^[2]

One tech tool, generative AI, is poised to play an especially prominent role in financial analysis. The same report concluded that by 2027, 40% of organizations will use generative AI to support and/or supplement management reporting.^[2]

In addition to generative AI, successful analysts also use:

• Accounting software. Accounting apps often come with features that automatically calculate financial ratios. As long as the data you've entered is accurate, producing a reliable ratio is only a few clicks away.

• Financial management software. Financial management apps can provide users with dashboards that factor in real-time financial data, providing deep insights via automated financial ratios.

• Business intelligence (BI) software. BI software uses financial ratios to automatically pinpoint trends and patterns you can use to decide how to steer your organization in a more profitable direction.

Start using financial ratios to improve business performance

Equipped with the information above, you can now decide which financial ratios are best to evaluate your organization's performance. In addition to answering a question many leaders have, "What are the important financial ratios?" you also know how to use them to assess your company's performance.