How to Use Financial Ratios to Make Smarter Business Decisions

When running a business, one of the most important things you can do is make informed decisions. Financial ratios are powerful tools that can help you understand the health of your business and guide you toward smarter decisions. These ratios simplify complex financial data, making it easier to spot trends, track performance, and identify areas that need attention.

In this blog, we’ll explore the most commonly used financial ratios and show you how they can help you make better business decisions.

What Are Financial Ratios?

Financial ratios are calculations that compare different financial elements of your business. They help you analyze various aspects of your company's performance, such as profitability, liquidity, efficiency, and solvency. By examining these ratios over time or comparing them to industry benchmarks, you can gain valuable insights into your financial health.

Key Financial Ratios to Track

Here are some of the most important financial ratios that every business owner should monitor:

1. Liquidity Ratios

Liquidity ratios help you understand your ability to pay off short-term liabilities with your current assets. Two key liquidity ratios are:

• Current Ratio: Formula: Current Assets ÷ Current Liabilities What it tells you: A current ratio above 1 indicates that you have more assets than liabilities, suggesting that you can cover your short-term obligations. However, a ratio too high could also suggest inefficient use of resources.

  
  

• Quick Ratio (Acid Test Ratio): Formula: (Current Assets - Inventory) ÷ Current Liabilities What it tells you: Unlike the current ratio, the quick ratio excludes inventory, offering a stricter test of your liquidity. A ratio of 1 or higher means your liquid assets are enough to cover your short-term liabilities.

  
  

2. Profitability Ratios

Profitability ratios help you assess how well your business is generating profit from its resources. Key profitability ratios include:

• Gross Profit Margin: Formula: (Revenue - Cost of Goods Sold) ÷ Revenue × 100 What it tells you: This ratio shows the percentage of revenue left after the cost of goods sold. A higher margin indicates better profitability.

  
  

• Net Profit Margin: Formula: Net Income ÷ Revenue × 100 What it tells you: The net profit margin tells you how much of every dollar earned is turned into profit after all expenses. A higher margin means better financial health.

  
  

3. Leverage Ratios

Leverage ratios provide insight into the level of debt your business is using and its ability to meet long-term obligations. Two key leverage ratios are:

• Debt-to-Equity Ratio: Formula: Total Debt ÷ Total Equity What it tells you: This ratio measures the proportion of debt used to finance your assets versus equity. A high ratio indicates higher financial risk, while a lower ratio suggests more stability.

  
  

• Interest Coverage Ratio: Formula: Earnings Before Interest and Taxes (EBIT) ÷ Interest Expense What it tells you: This ratio indicates how easily your business can pay interest on its debt. A higher ratio means you’re more capable of handling debt payments.

  
  

4. Efficiency Ratios

Efficiency ratios help you evaluate how well your business is utilizing its assets. Two essential efficiency ratios are:

• Accounts Receivable Turnover: Formula: Net Credit Sales ÷ Average Accounts Receivable What it tells you: This ratio shows how quickly you collect payments from your customers. A higher ratio indicates that you’re efficiently collecting receivables.

  
  

• Inventory Turnover: Formula: Cost of Goods Sold ÷ Average Inventory What it tells you: This ratio measures how quickly you sell your inventory. A higher turnover ratio means you’re selling and replacing inventory quickly, which is good for cash flow.

How to Use These Ratios to Make Smarter Decisions

Now that you know some of the most important financial ratios, let's look at how you can use them to make smarter business decisions:

1. Evaluate Your Profitability

By tracking your gross profit margin and net profit margin, you can identify whether your business is generating enough profit to cover your expenses. If your margins are low, you may need to adjust pricing, reduce costs, or find more profitable product lines.

2. Assess Your Liquidity

The current ratio and quick ratio will help you assess whether you have enough liquid assets to cover your short-term liabilities. If these ratios are too low, you may need to find ways to increase cash flow, reduce liabilities, or adjust your inventory.

3. Monitor Your Debt Levels

The debt-to-equity ratio will show you if you’re relying too heavily on debt to finance your business. A high ratio may indicate that your business is more vulnerable to economic downturns. If this is the case, you might need to reduce debt or restructure your financing.

4. Improve Efficiency

Efficiency ratios like the accounts receivable turnover and inventory turnover will tell you if you’re managing your assets effectively. If these ratios are low, it could be a sign that you need to speed up collections or streamline your inventory management.

Conclusion

Financial ratios are a vital tool for any business owner. By regularly reviewing and analyzing these ratios, you can get a clearer picture of your financial health, identify areas for improvement, and make smarter, more informed decisions. Remember, understanding your numbers is the first step toward long-term business success.

If you’re unsure about how to calculate or interpret these ratios, consider booking a strategy consultation with one of our financial experts. We're here to help you turn data into actionable insights.