Explained: Financial Ratios For Small Business

Any owner of a small business needs to be on top of the kind of financial figures that help them to understand whether their business is performing as it should. While events such as year-end accounts and audits help to create a broad and detailed picture, it also helps to be able to ascertain how well or otherwise various aspects of the business are performing on an ongoing basis. 

The sheer amount of financial data that floods into even the smallest business on a daily or even hourly basis can make capturing this kind of snapshot of performance difficult, however. By the time a problem is identified by a process such as a quarterly review it might already have caused significant damage. The key financial ratios for small businesses operate as a kind of shorthand that captures significant metrics to create a snapshot of how particular aspects of the business are operating. Some of the most important financial ratios for small businesses are as follows:

The cash flow to debt ratio

The calculation is: Net income divided by total debt = the cash flow to debt ratio 

Carrying a debt that doesn’t fall due until a later date can create a misleading impression of how healthy the cash flow of a business actually is. Many early-stage businesses fail due to cash flow issues when money borrowed to establish the business suddenly needs to be repaid. Calculating the cash flow to debt ratio will enable you to establish whether your business will be able to cover the bills it needs to pay and the debts it carries from existing cash flow.      

The net profit margin 

The calculation is: Total revenue minus total expenses divided by total revenue = the net profit margin

The net profit margin highlights how much of the revenue a business generates is left after all operating expenses are deducted. It is the figure that potential investors are often likely to ask for, as it demonstrates the efficiency with which a business is handling costs and converting revenue into profit. If the net profit margin is low or decreasing it could point to problems such as poor sales, increasing costs or out of control overheads. 

Gross margin ratio

The calculation is: Sales minus the cost of goods sold divided by total sales = the gross margin ration

This financial ratio is of particular importance to any business that sells products. It provides a snapshot of how much money is available for overheads such as marketing, rent and employee costs after the initial payment for the product has been made. The margin can be measured across the business as a whole or in terms of particular products, and a low gross margin indicates that the business could struggle to meet operating expenses in the future.  

Sales per employee ratio

The calculation is: Annual revenue divided by the number of employees = the sales per employee ratio

The sales per employee ratio is particularly useful for those businesses – such as those in the service industries – that need a high number of employees. If the ratio is high, it indicates an efficient use of resources, and it needs to be monitored carefully during periods when more employees are being taken on. If the ratio slips lower when more employees join it could indicate that the systems and processes in place need to be tweaked in order to maintain operational efficiency.   

We Can Help

If you’re interested in finding out more about financial ratios, or any other aspect of your business finances, then get in touch with our financial experts at GoCardless. Find out how GoCardless can help you with ad hoc payments or recurring payments.