You’ve received your financial statements for the year, and now you’re staring at a balance sheet, income statement and cash flow statement hoping to derive some answers from your financial reporting. But what does any of it even mean?
How do you know if your business is in a good spot or if you are even improving?
Let’s look at some items you should look for in your financial reporting and simple financial ratios to calculate to measure your growth and success.
What are Ratios in Your Financial Reporting?
Financial ratios show your company’s performance in critical areas, such as how well you can cover your debt. They allow you to understand your financial statements and track your performance over time.
Financial reporting and financial ratios don’t have to be complex. Some simple calculations can offer so much insight into your business financials.
Financial Reporting – Balance Sheet Ratios
1. Current Ratio
Current ratio measures liquidity which is how easily current assets can be converted to cash to cover short-term liabilities.
The higher the current ratio, the more liquid your company is and, therefore, the easier you can cover your short-term debts. While your business may not be there yet, a current ratio between 1.5 and 3 is considered healthy.
Current Ratio = Current Assets / Current Liabilities
Both current assets and current liabilities are items to be either received or owed within the year and should be shown as subtotals on your balance sheet. If they aren’t, here’s what each should include:
- Current assets include accounts such as cash and cash equivalents, marketable securities, accounts receivable and inventory.
- Current liabilities include accounts such as bank overdrafts, accounts payable, accrued expenses, and the current portion of long-term debt.
2. Quick Ratio
Quick ratio measures how well you can pay debts with highly liquid assets. A standard quick ratio is one or more as companies below one will fail to pay off current debt obligations if left as is.
Quick Ratio = (Cash & Cash Equivalents + Marketable Securities + Accounts Receivable) / Current Liabilities
Inventory is not included in the quick ratio because companies usually cannot sell stock at the drop of a hat without offering considerable discounts to encourage customers to buy quickly.
3. Debt to Equity Ratio
The Debt to Equity Ratio measures how much your business relies on equity versus borrowed funds. A healthy debt to equity ratio is between 1 and 1.5.
Debt to Equity Ratio = Total Debt / Owner’s or Shareholder’s Equity
While how you fund your company varies based on the situation, a very high debt-to-equity ratio is often associated with increased risk as the company has aggressively financed its growth with debt.
Financial Reporting – Income Statement Ratios
4. Gross Profit Margin
Gross Profit Margin measures how much your business makes per dollar earned, excluding general operating expenses, which you have to spend to keep your business running, such as rent and utilities.
Gross Profit Margin = (Net Sales – Cost of Goods Sold) / Net Sales
Net Sales is sales revenue subtracting any returns, allowances and discounts.
Gross profit margin can be improved by increasing prices or lowering the cost of goods sold, such as receiving discounts for buying in bulk or implementing automation.
5. Operating Profit Margin
Operating Profit Margin measures how much your business makes per dollar earned, including general operating expenses.
Operating Profit Margin = EBITDA / Sales Revenue
EBITDA means earnings before interest, taxes, depreciation and amortization, so you take your net income and add back those expenses.
The purpose of using EBITDA is to remove factors that business owners have discretion over, such as debt financing, methods of depreciation and taxes and therefore shows the firms’ financial performance without the impact of its capital structure.
6. Net Profit Margin
Net Profit Margin measures the relationship between your bottom line and your sales revenue.
Net Profit Margin = Net Income / Sales Revenue
A company with a higher net profit margin than others in its industry is more efficiently converting revenue into profit, which is important as that translates into cash in the bank.
If you are comparing ratios to those of your peers, be sure to only compare to those in your industry, as ratios between industries can vary significantly.
Financial Reporting – Cash Flow Statement Ratios
7. Current Liability Coverage
Current Liability Coverage measures how much cash you have available to pay off debt in the near future.
Current Liability Coverage = Net Cash From Operating Activities / Average Current Liabilities
Average current liabilities are calculated by taking current liabilities at the beginning and the end of the period and adding them together, then dividing them by two.
If your current liability coverage exceeds one, you have enough money to pay off your current liabilities.
8. Cash Flow Coverage
Cash Flow Coverage measures how well you can pay off debt with cash.
Cash Flow Coverage = Net Cash From Operating Activities / Total Debt
Your cash flow coverage represents the number of times you can pay your principal and interest with your current cash flow.
9. Cash Flow Margin
Cash Flow Margin measures how efficiently you convert your sales into cash.
Cash Flow Margin = Net Cash From Operating Activities / Net Sales
If your cash flow margin is negative, your company loses money even though it generates positive sales revenue. It may indicate the need to borrow or raise money through investors to continue unless your company has invested in a project that is expected to increase cash flow when complete.
Need Help Analyzing Your Financial Reporting?
When you understand and can analyze your financial statements, you can make sound business decisions based on valuable insights throughout the year.
This is where Shetland Financial can help. We’ll produce monthly or quarterly financial statements, so you know where your money is going and help you understand what to look for.
Contact us today to learn more about our financial reporting services and how we can help you grow your business.