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Key financial ratios help you monitor your performance and steer your business
Are you a founder or small business owner with a non-financial background? Do you want to improve your understanding of the key financial metrics and ratios that will tell you how well your business is performing?
Key ratio analysis is a vital management tool for any small business and financial ratios are among the most important of all the ratios you should master. Having a good grasp of the most common key financial ratios can help you to:
Spot emerging problems or weaknesses early on before they become serious.
Identify opportunities for improvement that can lift your cash flow.
Gain better overall control of your business.
In this article I explain some of the most important financial ratios and metrics for non-financial entrepreneurs. I’ve used plain English and avoided jargon. When I’ve used any technical terms, I’ve explained them clearly in simple language to make them easy to understand.
I explain what each metric tells you, show you how to calculate it and include tips for how you can use it to generate performance improvements.
Here are the groups of metrics I cover in the article:
Sales: growing the value of your business
Sales growth
Sales growth is one of the most important metrics for any business. Provided your business is profitable, growing sales make your company more and more valuable. That could mean a higher stream of long-term dividends for you or even a higher sale price if you ever decide to exit the business.
Here’s how to calculate sales growth:
100 x (sales in the current period/ sales in the comparison period -1)
Sales growth looks like a simple metric but it can yield much more insight than you might think at first sight.
One key question to ask is: which period should you calculate it for?
Businesses usually calculate their sales growth year over year (YoY). And they usually compare their performance for a period of a month, a calendar quarter or a whole year.
That usually makes sense, especially if the sales from your business are seasonal. If sales are higher at some times of the year (e.g. in the run up to Christmas) and lower at others, calculating your growth against the same period in the prior year will compare like with like.
Yet it can be helpful to calculate your sales growth over different periods. Here are some examples.
If your business is very young and fast-growing, it could make sense to calculate your sales growth each month relative to the immediately preceding month. That way you can check that your business is continuing to grow consistently.
If something is starting to go off track in your business your sales might flatline or fall sequentially (i.e. relative to the previous few months). Yet your sales might still be a lot higher than in the same month last year. You’ll only pick up the slowdown if you track your sales against the immediately preceding months.
A downside of calculating month-on-month sales growth is that it makes no allowance for the number of days in each month (although you can make some adjustments for that). It’s also the case that sales can be uneven when they’re measured over very short periods of time. For example, some businesses are impacted by the weather or even by the timing of when staff take their holidays.
To get a snapshot of the current trend of your sales growth while smoothing out the lumps you can calculate your growth in a rolling three-month basis. To do that, calculate your sales over the last three months and compare it with a suitable three month comparison period (e.g. the same three months last year or the immediately preceding three months).
Following a mixture of these approaches should give you the tools you need to evaluate whether your sales are growing in line with your targets.
Profitability: it’s the bottom line that drives the value of your business
Gross profit margin
Your gross profit margin measures the profit you make after deducting all the direct costs you incur to produce your product or service and deliver it to your customers.
Here’s how to calculate it: 100 x (sales - direct cost of sales) / sales
If you’re a manufacturing business, your direct cost of sales includes raw materials and components, manufacturing labour and the overhead costs for rent and utilities for your production facility.
If you’re a service business it includes the cost of your staff who deliver the service, the overhead costs they incur to do their jobs and any other directly attributable costs.
Operating profit margin
Your operating profit margin measures the profit you make after deducting all your operating expenses but before deducting interest and tax. Your total operating expenses include your direct cost of sales plus your indirect costs for departments like marketing, finance and HR.
Here’s how to calculate it: 100 x (sales – total operating costs) / sales
Net profit margin
Your net profit margin simply measures your profit after deducting all your operating costs plus your expenses for interest and tax.
Here’s how to calculate it: 100 x (sales – all costs) / sales
Contribution margin
Your contribution margin is the profit margin you make on each incremental extra unit of revenues.
Contribution margin is a very useful concept. It’s especially relevant if you need to evaluate the impact that a change in your level of sales would have on your profits. The change could be relative to the recent run rate of your sales (e.g. your monthly average over the last three months), to a budgeted level for this year or to any other level you have in mind.
Consider this. Some of your costs vary directly with your sales, such as your component costs to make a product and your shipping costs to deliver it. For obvious reasons these are called ‘variable costs’. Every time you make and sell another unit of your product or service, these variable costs increase proportionately.
In contrast to that, some of your costs are fixed — they don’t automatically rise in line with sales. These so-called fixed costs include things like the costs of running your finance function or your HR team. Producing an extra unit of output in your factory doesn’t require more of these costs.
Your contribution margin is the profit you make when your sales increase, assuming that your fixed costs remain unchanged and only your variable costs increase.
Here’s how to calculate your contribution margin:
100 x (sales – variable costs) / sales
When could it be useful to use contribution margin in your analysis? Here are a couple of simple examples:
If you have spare capacity in your business and you want to estimate how high your profits could go in the event you were able to fill that unused capacity by winning new customers.
If you’re concerned that demand from your customers may get weaker in the coming few months and you want to estimate how large the negative impact on your profits could be.
In a nutshell, contribution margin can be useful in any kind of scenario analysis or business planning exercise.
Return on equity
Return on equity (RoE) measures the amount of profit a company makes compared with the amount of money its shareholders have got tied up in the business. That money is called equity shareholders’ funds, or equity for short. You can find it at the bottom of a company’s balance sheet, underneath the company’s liabilities.
A company’s equity represents the money that its shareholders have put into the business in exchange for new shares plus the profits that the company has earned and retained within the business rather than paying it out to its shareholders as dividends.
Here’s how to calculate RoE:
Return on Equity = net profit / equity
You can either use the value of your company’s equity at the start of the year or the average of the values at the start and end of the year. Don’t use the figure at the end of the year on its own — it doesn’t properly reflect the equity that the company had at its disposal during the year.
Return on equity is a very important financial metric — some people would argue the most important one of all. That’s because the higher your company’s RoE, the more efficiently the company is using the money you’ve got invested in it. And the more efficiently it uses your money, the wealthier your company is likely to make you in the long run.
Return on assets
Return on assets (RoA) measures the amount of profit a company makes compared with the total assets the company has on its balance sheet. That’s to say the sum total of its fixed assets (equipment etc), its current assets (like inventory and receivables) plus any cash on hand.
Whereas RoE measures a company’s profitability from the perspective of the shareholders, return on assets measures it more from the perspective of the company itself. It’s simply a snapshot of how well the company is using all the assets at its disposal to turn a profit.
Here’s how to calculate RoA:
Return on Assets = net profit / total assets
If you monitor the trend in your return on assets over time and compare it against the trend in return on equity, you can better understand what is driving any changes in your company’s profitability.
For example, if your RoA is flat but your RoE is rising, that’s probably telling you that the operational performance of your business is stable but you’re finding ways to grow the business in other ways, i.e. through funding from third parties (loans or trade credit) rather than your shareholders having to put more money in themselves.
Financial efficiency: turning profits into cash flow
Days of receivables
This metric measures how quickly you collect the money owed to you by your customers.
Here’s how to calculate it: 365 x trade receivables / sales
Your level of outstanding receivables in days of sales will depend on two main factors:
Your terms and conditions with your customers, which will specify the length of the credit period, if any, you grant them before their payment is overdue. In many industries there are unwritten rules of the road regarding the amount of credit that suppliers customarily grant to customers. 30 days is common.
Any delinquencies by your customers. Powerful customers sometimes abuse their power by deliberately paying their suppliers late, reckoning they won’t cut off supply. Other customers may be in financial trouble and find themselves unable to pay what they owe on time.
You don’t have to follow the common rules of practice in your industry but, if you don’t offer the usual credit period, you may find it harder to generate sales.
If a customer is repeatedly late paying their invoices, don’t ignore the situation. If it’s a big, solvent customer, work out whether the sales you make to them are still profitable if you factor in the extra financing cost of constant late payment. If it’s a small customer and you’re concerned about bad debt risk, remember that a sale is worth nothing until you’ve received the customer’s cash.
Days of inventory
This metric measures how much inventory you have on hand.
Here’s how to calculate it: 365 x inventory / cost of materials in your profit and loss account
Ideally you want to hold as little inventory as possible — holding inventory has a cost. That cost is either the return you could earn on your money if it weren’t tied up in your business or else it’s the interest expense your company pays on the borrowings it uses to finance the inventory.
On top of that, if you sell products that are subject to fashion trends or technology innovation, you face the risk that some of your stock might become obsolete. If it does, you could end up having to scrap it.
On the other hand, you don’t want to hold too little inventory and find that it disrupts your business (e.g. your production team runs out of components) or loses you sales (if customers want to buy one of your products but you’ve run out of stock of finished goods).
So you need to strike a balance. Either way, you should have a good idea of what represents a normal healthy range for your inventory. If it goes above or below that level, you need to take corrective action.
Days of payables
This metric measures how much time you take to pay your suppliers.
Here’s how to calculate it: 365 x trade payables / costs of goods and services bought from trade suppliers in your profit and loss account
Your level of outstanding trade payables will depend mainly on the credit terms you agree with your suppliers. It hardly needs saying that you should pay your suppliers on time.
The amount of credit your suppliers give you can be a consideration when choosing between them. If two suppliers offer equivalent quality and service but one offers longer to pay than the other, that’s a legitimate reason to choose them as your supplier.
Cash conversion cycle (aka working capital cycle)
Your cash conversion cycle measures the length of time your cash is tied up in working capital before it converts back into cash. It’s the time period from when you pay your suppliers for your raw materials to the point at which your customers send you the cash to settle your invoices.
Your working capital is your net current operating assets, i.e. your net current assets excluding your cash and any short-term financial investments.
You may already have realised that the way to calculate it is like this:
Cash conversion cycle = inventory days + trade receivables days – trade payables days
The cash conversion cycle metric is mainly applied to manufacturing businesses because companies with production operations usually have longer working capital cycles.
If you’re a service business your working capital cycle will often approximate your days of trade receivables, although if you run a project-based business it could be longer. You’d need to deal with this scenario on a case by case basis.
You should want to keep your cash conversion cycle as short as you can, consistent with avoiding stock outs and with paying your suppliers on time.
Working capital ratios
There are two other common ratios you can calculate that measure the amount of working capital your business uses.
The first ratio is your net working capital as a % of sales.
Here’s how to calculate it:
100 x (Inventory + trade receivables – trade payables) / sales
The second is your net working capital turnover ratio.
Here’s how to calculate it:
Sales / (Inventory + trade receivables – trade payables)
As you can see, your net working capital turnover is just the inverse of your working capital to sales %. For example, if your net working capital to sales ratio is 25% then your net working capital turnover ratio will be 4x (i.e. you turn over your working capital 4x annually, which is broadly the same as a 3-month cash conversion cycle).
As we’ve already discussed in connection with your cash conversion cycle, the lower your net working capital as a % of sales or the higher your net working capital turnover ratio, the better.
Fixed asset turnover ratio
Your fixed asset turnover ratio measures the relationship between your sales and your fixed assets. For this reason, it’s mainly used in businesses that use a considerable amount of fixed assets, such as manufacturing businesses. However, it can be applied to companies in any industry.
Here’s how you measure it:
Fixed asset turnover = sales / fixed assets
The higher the ratio, the more efficiently you’re using your fixed assets to generate sales.
Liquidity: having the cash to pay your bills
Current ratio
The current ratio is a measure of the likely ability of a business to meet its current or short-term liabilities (i.e. those with a due date within the next 12 months) as they fall due.
Your current ratio is calculated like this: current assets / current liabilities.
Current assets comprise inventory, trade receivables, prepaid expenses and cash. Current liabilities comprise trade payables, accrued expenses and short-term debt.
The higher the ratio, the more comfortable your liquidity position would appear to be. That’s because ‘current’ assets are those that are expected to convert into cash within the next 12 months.
A ratio of less than 1.0 could be a cause for concern.
Quick ratio
Your quick ratio is another measure of the likely ability of a business to meet its current or short-term liabilities as they fall due. It’s more conservative than the current ratio because it excludes inventory from the calculation.
The reasoning is that inventory is usually some distance from converting into cash — it must be sold first and then the proceeds of the sale collected. On top of that there is a risk that the inventory becomes obsolete before it can be sold.
Your quick ratio is calculated like this: (trade receivables + prepaid expenses + cash) / (trade payables + accrued expenses + short-term debt).
Again, a ratio of less than 1.0 could be a cause for concern.
Operating cash flow
Operating cash flow is the cash that a company generates from its operations after allowing for any changes in the amount of cash tied up in working capital but before deducting any outlays for capital expenditure (i.e. spending on long-term assets like buildings, machinery, IT hardware etc) or from the draw down or repayment of loans.
Here is the formula to calculate operating cash flow:
Net profit + depreciation expense +/- any other non-cash income or expenses +/- changes in working capital
(You add back the depreciation expense that appears in your profit and loss account because it is a non-cash accounting charge).
Operating cash flow tells you how much cash a company is generating. That cash can be used for capital expenditure, loan repayments, dividend payments or any other non-operating use.
Free cash flow
The formula to calculate free cash flow is: Operating cash flow – capital expenditures.
Free cash flow therefore measures how much cash a company has generated, after paying for any capital expenditures, that can be applied to repay loans, pay dividends to shareholders or for any other non-operating purpose.
Free cash flow is a very important metric for both lenders and equity shareholders. While free cash flow can be volatile in the short term, in the long term it is a key input into any estimate of the value of a business.
Cash burn rate
Cash burn is a concept used to measure the amount of cash a loss-making business (usually a startup) is using and how long it will be able to keep going before it runs out of cash and potentially must shut down.
There are several ways in which the cash burn concept can be used.
Some people use the term simply to refer to the fixed operating costs of a business.
The figure is usually quoted per month and is sometimes called a company’s ‘gross cash burn rate’. For example, if Company A has salary and other costs of £10,000 per month, this is said to be the amount of cash it is ‘burning’ per month.
Other people refer to the burn rate as a company’s monthly cash outflows, after factoring in the gross profits from any sales the company is making. This is sometimes referred to as its ‘net cash burn rate’. For example, if Company A were generating gross profit of £3,000 per month, it’s ‘net cash burn rate’ is said to be £7,000 per month.
Finally, the term can also be used to refer to the number of months of cash a company has left on hand. For example, if Company A has £56,000 of cash on hand, it is said to have eight months of cash on hand at its current cash burn rate (being £56,000 / £7,000).
Financial and operating leverage: your sensitivity to changes in circumstances
Interest cover
This ratio measures how comfortably a company can cover the interest expenses on any loans it’s taken out.
Here’s how you calculate the ratio:
Interest cover = operating profit / interest expense
Any number below 3x used to be seen as a concern. If the ratio dips below 1x then this means the profit stream from your business would not be enough to service your interest payments. In the long run this would raise the risk of insolvency.
Interest cover is a good rule of thumb to apply to established businesses. Some would argue that the rule is less relevant for startups, many of which post losses for several years before turning profitable. As they have no profits, they would service the interest on any loans out of capital they’ve raised from investors.
However, that’s not entirely true. In the end, any business needs to be able to service its debt interest and have funds left over to invest for growth and pay dividends to shareholders. But for a period of time, if a company has a robust business model and just needs time to scale up, low or negative interest cover may not be a sign of financial distress.
It’s worth noting that interest cover doesn’t tell you anything about the size of the debts a company has. If interest rates are very low, as they were until the end of 2021, then even large debts may give rise to little interest expense. In those circumstances, interest cover may look very comfortable. But if interest rates rise, interest cover may fall dramatically.
The same can happen if your profits are temporarily very high. If your market is ‘hot’ you might have no trouble generating sales and pushing up your prices and margins. But if your market comes under pressure, and prices decline and your profit margins shrink, your interest cover can deteriorate rapidly.
In either case, what looked comfortable can quickly look stretched. If both trends happen at once, a company can find itself in trouble.
Debt to equity ratio
That’s why it also pays to monitor your debt to equity ratio. This measures how dependent your company is on debt financing and therefore how exposed your bottom line profits are to any negative shocks.
Here’s how to calculate the ratio: 100 x debt/ equity
There’s no hard and fast rule for what represents a comfortable level of debt/ equity. The key issue is your ability to service the interest (and potentially repayments) on your debt. That’s a function of the profitability you earn on your equity and the rate of interest you pay on your debts:
Profitability. If your company is active in a business that usually enjoys healthy profitability you’ll be able to carry a higher level of debt than one which struggles to generate profits. I’ll cover return on equity in detail below.
Interest rates. If interest rates are low you can support a higher level of debt than if rates are high.
Companies also feel able to carry more debt if their profits are stable and predictable than if they are volatile and unpredictable. You need to meet your interest payments every year. If your profits slump it may not help much if they’re forecast to rebound in two years from now.
Fixed cost coverage
The interest cover ratio tells you how readily your profits can service your interest costs. You need to know that because interest costs are fixed — you must pay them when they’re due. You can’t put them off or decide to reduce them.
Interest isn’t the only fixed cost in your business and it’s usually not even the largest. Here are some of the other costs your business may incur that are wholly or largely fixed:
Staff wages. You can’t use your staff one day and send them home the next if you don’t need them. You may employ agencies or freelancers on flexible contracts but those tasks may be mission critical (e.g. IT maintenance). If you can’t do without a function then its costs are effectively fixed even if the activity is outsourced.
Office or factory rent. Traditional property leases usually run for five years. If you’re a small business and you need flexibility you can pay a premium for a lease that’s more flexible but you’ll still be locked in for a few months. And even if you have a flexible lease, the cost is effectively fixed if you can’t run your business without the property.
Equipment rentals. Your business may need IT equipment, vehicles, machinery and other equipment that you rent on contracts that last for months or a few years.
Utilities. Your buildings need heat, light and water.
Subscriptions. You may incur significant costs for software and data, both of which are usually provided as services via subscription. You can usually cancel with minimal or no notice but if your business can’t run without these subscriptions then these are effectively fixed costs as well.
You can calculate a ratio for your fixed cost coverage. It measures how comfortably you’re covering your fixed costs.
You calculate the ratio like this:
Fixed cost coverage = (sales - variable costs) / fixed costs.
The value to use for profit after variable costs is the same value you would use to calculate your contribution margin (see above).
The lower the ratio, the more sensitive your profits will be to any drop in sales (or any step up in your fixed costs).
Investment: are you spending enough?
Capital expenditure (‘capex’) to depreciation ratio
All other things being equal, a high level of free cash flow is a good thing. But there are different ways to generate high free cash flow. One of them is to under-invest in the fixed assets of your business. It gives you a big cash flow boost for a while but in the long run you’ll face a big bill as your equipment wears out and eventually needs replacing.
In the meantime, your performance may deteriorate if the equipment or systems you’re using become mechanically or technologically dated, making them more expensive to run or more prone to producing faults or errors.
For that reason, it’s usually better to spend a little and often on capex, rather than going from famine to feast and back again.
How can you tell if you’re under- or over-investing in your fixed assets?
One helpful rule of thumb is to monitor the relationship between your capital spending and the depreciation expense in your profit and loss account.
Here’s how to calculate the ratio:
Capital expenditure / depreciation expense
Remember that your depreciation expense follows an accounting rule that spreads the cost of using an asset over its expected useful life. If you buy a piece of equipment for £10,000 and expect it to last 10 years, you would normally charge £1,000 of depreciation expense annually.
If your business is in a steady state — neither growing nor shrinking — it’s likely that your depreciation expense will be roughly equal to the amount you’ll need to spend on capex each year to replace items as they wear out. If your business is growing strongly then you’d normally need to spend more than your depreciation expense on capex to support your growth — sometimes many times more.
If you find that your capex is less than 1x your depreciation there’s nothing wrong with that. It may be that you use just one or two pieces of expensive equipment. You have to spend a large sum every few years and in between your cash flow is buoyant as your capex needs drop to nearly zero.
If that’s the case — fine. But be aware that this is how your cash flow profile works. Don’t be lulled into a false sense of security and project strong cash flows every year. Make sure your financial planning includes allowance for a big outlay every few years.