Using Accounting Ratios in Your Small Business

... back to syllabus

7 Jan 2014

Now that you have a better idea understanding of your Balance Sheet and Profit & Loss Account, there are a number of ratios and KPIs (Key Performance Indicators) that you can work out from the information in the accounts. These ratios and KPIs can be extremely useful when measuring the profitability and value and liquidity of your business. They can also be very helpful in identifying trends and potential weaknesses and risks in your business.

Here are (in our view) the most important ratios that you need when analyzing your business financials:

1. Gross Margin Ratio

The gross profit margin is a number which indicates the efficiency of a company in converting purchases of goods or materials to sales. A higher gross profit margin shows more efficiency of the company at converting its revenue into actual profit. This ratio is a good way of making comparisons between companies in the same industry, for such companies are often subject to similar business conditions.

The formula for computing the Gross Profit Margin is:

                    Gross Profit / Net Sales 

2. Current Ratio

The current ratio is a liquidity ratio which estimates the ability of a company to pay back short-term obligations. This ratio is also known as cash asset ratio, cash ratio, and liquidity ratio. A higher current ratio indicates the higher capability of a company to pay back its debts. 

The formula used for computing current ratio is:

                    Current Assets / Current Liabilities

3. Quick Ratio

The quick ratio, also referred as the “acid test ratio” or the “quick assets ratio”, this ratio is a gauge of the short term liquidity of a firm. The quick ratio is helpful in measuring a company’s short term debts with its most liquid assets.

The formula used for computing quick ratio is:

                    (Current Assets – Inventories)/ Current Liabilities

A higher quick ratio indicates the better position of a company.

4. Return on Equity (ROE)

The return on equity is the amount of net income returned as a percentage of shareholders equity. Moreover, the return on equity estimates the profitability of a corporation by revealing the amount of profit generated by a company with the money invested by the shareholders. Also, the return on equity ratio is expressed as a percentage and is computed as:

                    Net Income/Shareholder's Equity

The return on equity ratio is also referred as “return on net worth” (RONW).

5. Net Profit Margin

The net profit margin is a number which indicates the efficiency of a company at its cost control. A higher net profit margin shows more efficiency of the company at converting its revenue into actual profit. This ratio is a good way of making comparisons between companies in the same industry, for such companies are often subject to similar business conditions.

The formula for computing the Net Profit Margin is: 

                    Net Profit / Net Sales 

Once you have the ability to analyze accounts formulaically, you can use the data to compare across other financial periods, or benchmark against other businesses in a similar industry sector.

For example, if you compare periods and the overall trend is a fall in net profit margin, then you need to drill into the data and try to establish why the profit margin is falling. Once you identify what the problem is - it could be that wages are increasing and need to be controlled, for example, then changes can be made.

In our view the two most important of the five most important ratios are Net Margin and The Acid Test Ratio. Keep an eye on these two ratios and your profitability and liquidity will always be measured. But remember measurement without management is worthless - if you identify problems from your ratio analysis, it is vital that you take steps to address these problems.