Expanding Your Business? Track These Financial Ratios!
You’ll get to a point where you feel, “Maybe I’m ready to take my business further.” Whether you choose franchising, expanding your product line, or acquiring another company, it’s a thrilling opportunity to push yourself in new directions.
Taking out the “maybe” is your starting point. Investors place a premium on certainty, and a mere elevator pitch won’t suffice to secure their backing. Your confidence in pursuing expansion must be substantiated by numerical evidence.
This article will unpack the importance of financial statements. We’ll explore what investors look for in them, and then analyze the key numbers – financial ratios – that provide valuable insights. Understanding and leveraging these ratios allows you to effectively communicate your business’s financial health and viability to potential investors.
Featured Topics:
- Financial Ratios as Tools to Summarize Your Financial Statements
- Kinds of Financial Ratios
- Focus on These 5 Financial Ratios
- Building Investor Confidence through Regular Monitoring & Continuous Improvement
Financial Ratios as Tools to Summarize Your Financial Statements
Financial statements are formal records that provide a snapshot of your business’s performance and position. This documentation includes the income statement, balance sheet, and cash flow statement. These financial statements are crucial tools that allow you and potential investors to assess your business’s financial health and stability.
Learn How to Read a Financial Statement Like A Pro (Even if You’re Not an Accountant)!
Investors won’t look at your financial statements line-by-line, so you must take a step ahead and know what they’re looking for.
Financial ratios typically summarize your financial statements. They are calculated by comparing different numbers from your financial statements to provide meaningful insights into your business’s performance and well-being. They help you assess your company’s liquidity, profitability, efficiency, leverage, and other vital aspects.
For investors, these ratios serve as vital indicators of your business’s potential for growth, stability, and return on investment. By analyzing ratios, investors can evaluate your business’s ability to generate profits, manage debt, utilize assets, and generate cash flow.
Tracking financial ratios not only helps showcase your business’s financial health to potential investors but also enables you to identify areas of improvement and make informed decisions regarding expansion strategies. It allows you to address weaknesses, capitalize on strengths, and align your financial goals with your business objectives. The role of financial management in a small business’s success and growth cannot be emphasized enough. It encompasses not just obtaining investments but also prudent resource management. Recent small business data for 2024 indicated that 38% of businesses meet failure due to depletion of cash reserves or challenges in obtaining additional capital.
Kinds of Financial Ratios
Liquidity Ratios
Liquidity ratios assess a company’s capacity to settle its immediate obligations within the specified time frame. They are crucial indicators of a company’s financial health and solvency.
Why We Track Them: Liquidity ratios provide insights into the business’s ability to weather financial challenges, meet financial obligations promptly, and make informed decisions regarding investments and expansion.
Here are the common liquidity ratios:
- Current Ratio
- Quick Ratio
Profitability Ratios
These ratios are fundamental financial metrics that assess a company’s ability to generate earnings relative to its expenses and other costs. They provide crucial insights into the effectiveness and efficiency of a company’s operations in generating profits.
Why We Track Them: Monitoring these ratios provides insights into the effectiveness of cost management, pricing strategies, and overall business profitability. Small business owners rely on profitability ratios to make informed decisions about resource allocation, pricing, and strategic planning to increase profitability and sustainable growth.
Key profitability ratios include:
- Gross Profit Margin
- Net Profit Margin
- Return on Investment
Efficiency Ratios
These financial indicators measure a company’s ability to utilize its resources effectively to generate revenue. These ratios assess the efficiency of various operational processes, such as inventory management, collection of receivables, and utilization of assets.
Why We Track Them: If the inventory turnover ratio is higher, it indicates effective inventory management, resulting in lower carrying costs and a decreased possibility of having obsolete inventory. Meanwhile, a higher accounts receivable turnover ratio indicates that a business efficiently collects payments, minimizing the risk of bad debts and improving cash flow. By optimizing efficiency ratios, companies can reduce costs, increase productivity, improve customer satisfaction, and boost profitability.
Two commonly used efficiency ratios are:
- Inventory Turnover Ratio
- Accounts Receivable Turnover Ratio
Solvency Ratios
Solvency ratios are financial metrics that evaluate a company’s long-term financial health and ability to meet its obligations in the long run. These ratios help assess a business’s capacity to repay its long-term debts and remain financially stable.
Why We Track Them: By assessing solvency ratios, businesses can determine their capacity to take on additional debt, make strategic decisions regarding capital investments, and identify potential risks or areas of vulnerability in their financial structure.
Two important solvency ratios are:
- Debt-to-Equity Ratio
- Interest Coverage Ratio
Growth Ratios
Growth ratios are financial indicators that measure a company’s ability to increase its earnings, revenue, or other critical metrics over a specific period. These ratios are essential for small business owners as they provide insights into business growth and help gauge the effectiveness of growth strategies.
Why We Track Them: Businesses can identify areas of success and potential challenges by analyzing these ratios. Understanding the factors driving growth or hindering it allows owners to adjust their strategies, allocate resources, and prioritize initiatives that offer the greatest returns. Growth ratios also help businesses benchmark their performance against competitors and industry standards to set realistic growth targets.
Two commonly used growth ratios are:
- Earnings per Share (EPS) Growth
- Revenue Growth
Focus on These 5 Financial Ratios
Let’s explore critical financial rations that investors use to evaluate businesses, equipping you to craft a powerful argument for expansion.
1. Current Ratio: Demonstrating A Strong Liquidity Position to Provide Confidence to Investors
The current ratio indicates a company’s capacity to satisfy its short-term obligations using its short-term assets. Investors closely examine this ratio to assess a business’s liquidity and capacity to meet its immediate financial obligations. A higher current ratio indicates a stronger liquidity position. By ensuring a healthy current ratio, you can instill confidence in investors, assuring them that your business can readily pay its debts and maintain uninterrupted operations.
Formula: Current Ratio = Current Assets / Current Liabilities
2. Gross Profit Margin: Highlighting the Profitability and Potential Returns on Investment
The gross profit margin ratio measures the profitability of a company’s core operations. It demonstrates the percentage of revenue remaining after subtracting the cost of goods sold. A higher gross profit margin signifies higher profitability and efficient cost management. This showcases the potential returns that investors can expect on their investments. Emphasizing a consistently healthy gross profit margin can attract investors looking for businesses with robust profit generation capabilities.
Formula: Gross Margin Ratio = Gross Profit / Net Sales
3. Accounts Receivable Turnover: Indicating Effective Cash Flow Management and Minimal Credit Risk
The accounts receivable turnover ratio evaluates how quickly a company collects customer payments. It reflects the efficiency of cash flow management. It indicates how effectively a business extends credit to customers and manages credit risk. A higher turnover ratio implies a shorter collection period and lower credit risk. Demonstrating a strong accounts receivable turnover ratio demonstrates efficient working capital management and reduced credit risk, making your business an appealing prospect for investors.
Formula: Receivables Turnover Ratio = Net Credit Sales / Average Accounts Receivable
4. Debt to Equity Ratio: Showing a Balanced Capital Structure and Financial Stability
The debt-to-equity ratio measures the proportion of a company’s financing provided by debt compared to equity. This indicates the degree to which a company is dependent on borrowed funds. Investors use this ratio to determine a company’s financial stability and risk associated with its capital structure. A lower debt-to-equity ratio suggests a healthier balance between debt and equity funding. Maintaining a balanced debt-to-equity ratio can present your business as financially stable, minimize risk, and make it an attractive proposition for potential investors.
Formula: Debt to Equity Ratio = Total Liabilities / Shareholder’s Equity
5. Net Profit Margin: Displaying Sustained Profitability and Positive Cash Flows for Investment Returns
The net profit margin ratio represents the percentage of revenue retained as profit after deducting all expenses, including taxes and interest. It demonstrates a company’s ability to generate sustainable profits and positive cash flows for potential investment returns. A higher net profit margin indicates effective cost control, efficient operations, and a favorable market position. Highlighting a consistently strong net profit margin showcases your business’s ability to generate attractive returns and can pique investor interest.
Formula: Net Profit Margin Ratio = Net Profit / Revenue
Building Investor Confidence through Regular Monitoring & Continuous Improvement
Focusing on these five key financial ratios can provide investors with valuable insights into your business’s financial health, profitability, liquidity, and efficiency. Presenting strong ratios can build confidence in potential investors, setting the stage for expanding your business and securing the necessary funding to achieve your growth objectives. Remember, regular monitoring and continuous improvement of these ratios will significantly develop your ability to attract investment and grow your business successfully.
Utilize financial management tools like QuickBooks to simplify ratio analysis and gain better insights. These tools and features allow small business owners to quickly generate financial reports, analyze liquidity ratios, and make informed financial decisions based on up-to-date data.
We understand that QuickBooks integration can present a significant learning curve. The good news is we have Certified QuickBooks ProAdvisors at MBE CPAs who can provide ongoing support. They will guide you through the transition, help train your employees, and answer any questions you might have.
This article is courtesy of Brand House Marketing. Check out their website to explore additional marketing resources to empower your business.