Six Financial Ratios That Are Important To Your Small Business
By: Thomas M. Nunnally
(Featured in Dynamic Business, December 1990)

The use of financial ratios can be especially important for the smaller business.  These businesses may not have the complexity of a multi-division corporation, however, small business owners can become so immersed in the daily operations that he or she can fail to see adverse trends developing.  Financial ratios can be the impartial indicators of the financial trends of the business.  They are the pressure gauges that should be read at least once a year.
Financial ratios do not have to be difficult.  Where there are dozens that are used by financial analysts, there are six that can be used by every small business owner.  These six ratios are often used by bankers to evaluate he performance of a potential borrower.
A word of caution.  Ratios are most effective when they are used to highlight trends.  They should be compared with each other over several years.  The absolute number is not as important as the direction of the trend.
Also, these comparisons should be made with like periods (third quarter compared with third quarter; year end with year end).  Seasonal sales volume changes and different inventory levels can distort the ratios if different financial reporting periods are compared.
The six ratios are:

1. Current Ratio—This is a measure of a company’s ability to pay current liabilities when due.  Since working capital is current assets minus current liabilities, this classic ratio is calculated by dividing current assets by current liabilities.  Many people feel that a 2.0 (2 to 1) ratio is sacred.  However, many businesses, especially cash businesses (no receivables), can operate comfortably with a lower ratio.  The importance of this ratio is that a declining current ratio over several years indicates that a business could be draining its working capital to pay for fixed (long term) assets.  Unless there was excess working capital to begin with, the company may find it has backed into a tight working capital position.
2. Profitability Ratio—This is calculated by dividing net profit by sales; the result is profit expressed as a percentage of sales.  A decreasing percentage may indicate that expenses are not being adequately controlled or that rising costs are not being covered through increased prices.  (Actually, each expense item should also be calculated this way and compared with previous years to highlight the expenses that are rising in relation to sales.)
3. Debt to Worth Ratio—This is calculated by dividing total debt (current and long term) by net worth (equity).  This can be an important ratio to your banker or other lender.  An increasing ratio indicates that a company is funding its growth primarily through debt.  While this is normal and permissible for a short term period (a couple of years), a long term trend indicates a basic weakness in the company.  At some point (some debt to worth level), lenders could (suddenly) refuse to grant further credit.  Management may have become unaccustomed to any other funding methods and may have difficultly in abruptly adjusting to financing exclusively through retained earnings.
   There is no absolute number for a debt to worth ratio where businesses could have trouble obtaining further credit.  Much depends upon the type of business and the assets that support the debt.  But as a broad, general rule of thumb, lenders could become concerned with a debt to worth ratio in excess of three to one or even two to one.
4. Receivable Turnover Ratio—This is calculated by dividing annual sales by account receivable.  (This can be further stated by dividing the turnover ratio into 360 to arrive at days sales in receivables.)  Example: $300,000 annual sales divided by $50,000 accounts receivable yields a turnover of 6; 360 divided by 6 equals 60 days receivables.  A decreasing turnover ratio (increasing days) may indicate that excess funds are being tied up in receivables or that receivables are not being adequately followed for timely payment.
5. Inventory Turnover Ratio—This is calculated by dividing annual cost of good sold by inventory, which can be divided into 360 to express inventory in days.  A decreasing turnover ratio (increasing days) may indicate that merchandise is not moving, thus tying up dollars that could be used for faster selling items.  At today’s interest rates, it can cost in excess of one percent month to carry inventory, thus surplus inventory can be expensive.  This ratio can be a red flag for management to place more attention on inventory control.
6. Payable Turnover Ratio—This measures a company’s performance with trade creditors, an important source of low cost financing.  The ratio is calculated by dividing purchases by accounts payable (which can be further divided into 360 to express payables in days).  A decreasing turnover ratio (increasing days) can indicate that suppliers are being delayed.  This may be the very first sign that a small business may be having capital problems.

Calculations of these six ratios will take only a few minutes a year, but can give the small business owner a great insight into the financial trends of his or her business.

Thomas M. Nunnally is a retired banker with over 30 years of experience in business lending.  In addition, he is the co-author of The Smaller Business Insider’s Guide to Bankers from Oasis Press.  It is available at the Enterprise Small Business Resource Center.