What are Financial Ratios and Why Should You Care?

Financial Ratios Blog | ClariFi Business Solutions

Owning a small business can feel like navigating rough seas while trying to get to shore in one piece. It can seem counterproductive to take some time out to pause, assess, and review things like financial ratios. But, it will make the difference between getting it to shore in good condition,  going off course, or possibly capsizing.

Financial ratios provide the insight you need to help you make better long-term financial decisions and improve the economic success of your business. The problem is your business expense sheets have so much information that it may be challenging to find the numbers that matter most. That’s where financial ratios come into play!

What are Financial Ratios?

A financial ratio is an equation using numbers from your business’s financial statements to help you understand your company’s financial health. The key documents to determine your financial ratios are your cash flow statement, balance sheet, and income statement. These ratios can then be used to determine your company’s growth, liquidity, return rates, leverage, valuation, and profitability.

The Importance of Financial Ratios

Why should you take time out of your already busy schedule to calculate your financial ratios? They can give you the critical information needed to make difficult business decisions. Financial ratios help you:

  • Track and measure the financial performance of your business
  • Make sound judgments regarding your business’s economic performance
  • Set business goals that support profitable outcomes
  • Compare your market position to your competitors
  • Analyze market trends

Inc. Magazine’s February 2020 article also reminds us, “It is important to keep in mind that financial ratios are time-sensitive; they can only present a picture of the business at the time that the underlying figures were prepared.” You’ll want to check your financial ratios regularly to get a monthly or quarterly snapshot throughout the year. This will help you see seasonal trends and compensate for economic fluctuations.

Financial Ratio by Category

Financial ratios can be organized into four categories:

  1. Liquidity
  2. Profitability
  3. Activity
  4. Leverage

Although there are many types of financial ratios within these four categories, we list the ratios most commonly used by small business owners.


Liquidity measures your company’s ability to cover all its expenses. There are two main financial ratios small businesses use in this category:

  • Quick Ratio = (Cash + Marketable Securities + Net Accounts Receivable) ÷ Current Liabilities
  • Cash Flow to Debt Ratio = (Depreciation + Net Income) ÷ Debt

The quick ratio, or acid test, helps you assess your business’s cash position. In other words, it tells you if you have enough assets to cover your current liabilities. This ratio will help you assess whether your business will survive temporary setbacks and if you need a cash investment to grow your business.

The higher the quick ratio, the stronger your cash position. For example, if your quick ratio is 2.0, you have $2.00 in assets for every $1.00 in liability – this is good news. If your quick ratio is 1.0 or less, your debts are more than your assets. Even bad news is good to know so you can make corrections.

The cash flow to debt ratio helps measure how much debt your company can manage. This financial ratio gives essential information because it discovers a weak cash flow position, which is the prime reason small businesses fail.

For example, a cash flow to debt ratio of 1.0 or less means your business can’t afford its bills without additional income or funds. A 2.0 ratio means your company can cover twice the debt, leaving your company with a strong cash flow.

In the December issue of Forbes Magazine’s Forbes Women, a U.S. bank study showed that 82 percent of businesses fail because of poor cash flow management and notes, “That’s a high rate of failure for a system that can be controlled easily.”


The financial ratios in this category determine how much profit your company generates. There are two profitability ratios that small business owners should use:

  • Net Profit Margin = (Total Revenue – Total Expenses) ÷ Total Revenue
  • Gross Profit Margin = (Sales – Price of Goods or Services Sold) ÷ Total Sales

A positive net profit margin shows your company is effectively converting sales to profit. The higher the profit margin, the more profit your company creates.

For example, a 15 percent profit margin means that the company keeps 15 cents of every dollar sold. If this ratio decreases over time, you may want to keep a closer eye on inventory and employee theft. It might be good to compare the number of office supplies bought to what is being used.

Gross profit margin determines how much is left over after goods are sold to pay for taxes, interest, and expenses. More money leftover gives you more flexibility to pay for other business expenses.

You can calculate this ratio by product or in total for your business. For example, a holistic retailer can measure gross margin by a single product, like herbal teas, or all of their products, like teas, lotions, spices, etc.


Activity ratios, also known as efficiency ratios, measure how effectively your company manages its assets. Small business owners use three main ratios in this category:

  • Accounts Receivable Turnover = (Total Accounts Receivable Outstanding ÷ Total Sales) x Number of Days
  • Sales Per Employee = Annual Revenue ÷ Number of Employees

Accounts receivable turnover determines how long it takes your company to get paid after goods are sold. If this number starts getting high, it’s a signal for you to focus on speeding up the receivable process.

If high inventory turnover ratios indicate that your inventory typically runs low, you risk selling out of products. Food industries with perishable inventory will likely have a higher inventory turnover ratio.

The sales per employee ratio will show you how well your workforce is managed and the productivity of your employees. It helps you keep tabs on your company’s growth as you add or reduce the number of employees in your business.


Financial ratios in this category help you decide whether your debt levels are appropriate. Leverage ratios are also known as debt, coverage, or solvency ratios. Although there are a few financial ratios in this category, there is one that is used most often:

  • Debt to Equity Ratio = Total Liabilities ÷ Shareholder’s Equity

Debt to equity determines the percentage of your business finances coming from creditors and investors, generally a ratio of 1 to 1.5 is considered optimal. The higher the ratio, the more creditor financing or loans are used rather than investor financing or shareholders. Investors and  lenders tend to get nervous when the ratio exceeds 2 as a high ratio can indicate difficulty generating enough cash to repay debt obligations.  On the other hand, a low ratio may indicate the company is not taking advantage of financial leverage in growing the company. .

Financial Ratios Matter to You and Your Business

According to the Director of the Women’s Bureau at the U.S. Department of Labor, Dr. Patricia G. Greene: “ Financial ratios lead to a deep understanding of your business and allow for industry comparisons. Just remember that industry standards are a reference, not a recipe.” Your business is unique and financial decisions may be based on several other factors.

ClariFI Business Solutions can help you understand all your business statements and numbers used to calculate financial ratios. We care about your company’s financial success and are eager to help you with your small business finances. We offer a free business health test and can help provide you with the much-needed insights to help your business grow. Please get in touch with me online or email me at jyaeger@clarifibusiness.com with any questions.