A critical component of running a successful business is understanding where it stands financially. This helps you see where you are today and predict how you’ll fare in the future. While there are many pieces of financial data to keep on top of, some critical ones are accounting ratios. These metrics can give you a quick idea of where your business stands and how well it is positioned to handle any obstacles that pop up.
What are accounting ratios?
Accounting ratios measure your company’s current and projected financial health. They are based on data in your business’s financial reports.
On the surface, accounting ratios may seem complicated, but each measures two line items that you should be able to access quickly and easily from your balance sheet. Here are the most common accounting ratios that small businesses can use.
A debt-to-equity ratio tells how leveraged your business is compared to what it’s worth, according to its shareholder equity (the amount of equity you have after the company’s debts have been paid). Your debt-to-equity ratio gives you and your prospective lenders an instant reading of your company’s financial health.
How to calculate debt-to-equity ratio
To find your debt-to-equity ratio, divide your company’s current debt load by its equity.
For example, if your company’s liabilities total $100,000 and its equity is $50,000, the debt-to-equity ratio would be 2. On the other hand, if the debt were $50,000, the debt-to-equity ratio would be 1, putting you in a safer position.
In general, a healthy debt-to-equity ratio is 1 to 1.5. If your ratio exceeds that, taking on more debt may be risky, because you may not have the capital to back up the amount you borrow.
High debt-to-equity ratios aren’t always negative. If your business is expanding, this ratio may be high because you are using the debt to finance the essentials that will translate to higher profits. For example, your restaurant may be doing so well that you have recently opened a fourth location and taken a loan to purchase commercial refrigerators. That loan balance will have increased your debt-to-equity ratio in the short term, but as you pay down the loan and turn a profit, that ratio will fall.
A debt ratio tells how leveraged a company is compared to its assets. That makes it a good indication of just how solvent your business is.
How to calculate debt ratio
To find your debt ratio, divide your company’s combined debts by its total assets.
A debt ratio doesn’t consider shareholders’ interests (you may not have any). Instead, it calculates how much of your company’s assets are financed. A 2021 report by Fed Small Business found that 44% of small enterprises have debts of $100,000 or more.
For example, if your company’s financial obligations are $50,000 and its assets are $100,000, your debt ratio is 0.5. That’s not bad, because it indicates that your company owes less than it owns. A debt ratio higher than 1, however, shows that your company has more liabilities than assets. In that case, your company is technically insolvent.
As with debt-to-equity ratios, an out-of-balance debt ratio can be alarming. However, if you have a viable plan to reduce overhead and turn the ratio around, your company may be in fine shape after all.
Did you know? Many top accounting software options can help track your accounting ratios. Learn more about some highly rated options in our review of QuickBooks Online, our FreshBooks review and our review of Zoho Books.
A current ratio assesses your company’s short-term liquidity, giving you a decent idea of whether you can satisfy your debts on schedule.
How to calculate current ratio
To calculate your current ratio, divide all of your company’s current assets by its current liabilities.
When managing loans and lines of credit, you need to be sure you can meet your financial obligations in the event of an unexpected downturn. That’s where current ratios come in. You may need to sell off assets to handle the debt without falling behind. A current ratio of 1.5 to 3 is in the financially healthy range.
For example, if your company has $10,000 in total assets and $5,000 in liabilities, your current ratio is 2. This means that for each dollar your company owes, it has $2 in assets, putting you on secure footing. If your current ratio is less than 1, you might experience problems with liquidity if you can’t secure additional financing to keep operating.
A quick ratio provides a sense of a company’s short-term liquidity based only on the assets that it can immediately liquidate.
How to calculate quick ratio
To calculate your quick ratio, divide your company’s quick assets by its current liabilities.
It can be alarming to be in a situation where you need access to cash but some of your assets are tied up and will take a long time to cash out. Quick ratios can help you sleep better at night.
Suppose something goes wrong, such as an unusually high expense that you need to cover right away. In that case, you’ll want to know which assets you can access or sell off without a lengthy process so that you can meet your company’s short-term financial obligations. If you can liquidate $100,000 and your current liabilities total that same figure, your quick ratio is 1. That proves you can scrape up enough funds to cover what your company owes.
For example, some of your company’s equity may be tied up in real estate holdings. You would remove that value from your total assets in a quick ratio scenario. That’s because you can’t predict how long it would take to sell the property, or even the exact price. Instead, concentrate on assets, such as your accounts receivable, cash in the bank, or cash equivalents such as certificates of deposit.
Tip: It is always better to over-prepare than under-prepare. Consider what can go awry, then ask yourself how you would handle each issue. Know the amount of cash you have on hand at any given time. If you need to borrow money, find out how much you could qualify for, and make sure you can handle the payments based on your revenue and current debt obligations.
Naturally, you want to know how lucrative your company is. You can find that information by calculating your return on equity. A return-on-equity ratio gives you an idea of your company’s overall profitability and how well it generates profits.
How to calculate return on equity
To find your return on equity, divide your company’s net income by its shareholder equity.
This ratio can also be described as the return on your company’s net assets. An attractive return on equity is usually 15% to 20%.
For example, if your net income is $10,000 and the shareholders’ equity is $60,000, the return on equity would be nearly 17%, which falls in the good range.
A high return on equity means your company uses shareholders’ equity efficiently to generate income, while a low ratio indicates inefficiencies. This ratio informs you – and lenders – just how well your company can turn a profit without requiring an influx of capital. It’s also essential for investors looking for a deal, since it can help them identify an undervalued company.
Gross margin ratio
Another way to measure your company’s profitability is with the gross margin ratio. This number gauges the profits of your company’s sales after the costs to produce your product or offer your service are removed from the equation. The higher your gross margin ratio, the more money your company keeps from sales.
How to calculate gross margin ratio
To find your gross margin, subtract the cost of goods sold from your total revenue, then divide the result by your total revenue.
The gross margin ratio helps assess your company’s financial health and its sales profitability after direct costs are subtracted. Moreover, this ratio gives you an indication of production efficiencies and the crucial break-even point. If what you’re selling is costing you the same amount or more to produce, that is a red flag.
A good gross margin depends on where you are in the life cycle of your business as well as your industry. In general, though, 5% is considered low, 10% is moderate, and 20% and above is great.
FYI: Keeping an eye on your company’s gross margin ratio will allow you to reduce costs (if possible) or raise prices while remaining competitive.
Yet another useful profitability ratio is the return on assets. It compares the value of your company’s current income against the profits it generates during that same time period. The return-on-assets ratio shows how much profit your company generates from its assets – that is, how efficiently your company is using its resources to turn a profit.
How to calculate return-on-assets ratio
To find your return on assets, divide the company’s net income by its total assets.
A higher return on assets is ideal because it is a measure of efficient operations. What constitutes a good return on assets depends on various factors, but 5% is typically considered good. It shows you are earning 5 cents per dollar in assets. A return on assets of 20% is great, because it shows you are earning 20 cents for each dollar you have in assets.
Maintaining awareness of your company’s return on assets allows you to make adjustments before an operations issue becomes problematic, as it highlights inefficiencies.
Tip: Make a standing appointment on your calendar to review paperwork and organize your documents. Even if you have an accountant or bookkeeper, do some of these tasks yourself at least monthly.
Bottom line on accounting ratios
Running your own business, no matter its size, requires attention to detail. Accounting ratios will keep you on the right track. By checking these numbers on a regular basis, you will have more time to dedicate to your passion instead of putting out fires. These accounting ratios will also give you a clear vision of where your company stands today so you can plan for not only potential emergencies, but also profits and growth.