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Comparing Your Financial Ratios to Industry Standards

Business woman studying her business's financial ratios

Knowing your financial ratios is critical to managing your small business successfully. If you are applying for a business loan, the lender will want to see that your net operating income is more than sufficient to cover your loan payments. In fact, most lenders expect net operating income to be approximately three times the required loan payment. This standard holds true across the industry.

However, other ratios can vary greatly depending on the type of business you have. For example, inventory turnover should be much faster in a restaurant or grocery store compared to a retail clothing or appliance store. Grocery stores often have low profit margins per item but sell a large volume of products, while appliance stores sell fewer items but need a higher margin per sale to stay profitable.

Fortunately, there are several sources of standard industry data that can help you assess how your business compares to industry averages. These resources include:

  • IBISWorld: Offers comprehensive industry analysis, financial statistics, and industry trends. It’s a fee-based service, but you may be able to access it for free through a university or public library. Many Small Business Development Centers (SBDCs) use these reports in client consultations.
  • ReadyRatios: This financial software allows business owners to input their financial statements and automatically calculate key financial ratios. It also compares your business’s performance to industry benchmarks. ReadyRatios offers both free and fee-based versions depending on your needs.
  • Statista: A platform providing a wide range of data, including industry-standard ratios, market trends, and consumer behavior. It also has both free and premium options.

Other sources include:

  • Trade Associations
  • U.S. Census Bureau
  • Bureau of Labor Statistics
  • Market Research Firms

Key Ratios to Compare

There are several important financial ratios you can use to assess your business’s performance. Here are a few to consider:

Revenue Growth

If your industry is experiencing strong revenue growth but your business is lagging behind, it’s important to investigate why. Ask yourself:

  • Are new competitors eating into your market share?
  • Have you cut back on marketing and advertising?
  • Are you failing to provide an exceptional customer experience?

Profit Margin

Before starting your business, you should research the industry’s standard profit margin and compare it to your projected margins. If you’re projecting a profit margin much higher than industry standards, you’ll want to carefully review your assumptions about costs and operating expenses. If your business is already running and your profit margin is too low, consider:

  • Are your costs rising faster than you’re able to increase prices?
  • Are you failing to collect receivables in a timely manner?
  • Have revenues fallen below the point where they can cover fixed costs?
  • Has the quality of your product declined, leading to returns and waste?

Cost of Goods Sold (COGS)

The COGS ratio varies widely by industry, and yours should align with the industry’s average. If it’s not, investigate the following:

  • Are your prices too high, leading to reduced sales?
  • Is your markup too low, cutting into profits unnecessarily?
  • Are you offering deep discounts to move inventory, suggesting a misalignment with customer demand?
  • Are you over-ordering perishable items, resulting in waste?

Inventory Turnover Ratio

Your inventory turnover ratio indicates how quickly you’re selling and replacing inventory. If your ratio is higher than the industry average, it may indicate that you’re turning over inventory too quickly, which could lead to lost sales on high-demand items. On the other hand, a lower turnover ratio could mean that you’re ordering too much or the wrong items. Striking the right balance between inventory levels and demand is key to boosting sales and minimizing excess investment.

Interpreting Industry Benchmarks

These are just a few of the key financial ratios you can compare. It’s important to remember that deviating from the industry standard doesn’t necessarily indicate a problem, but it should prompt further investigation. You may find that your business is more efficient than average, or you may uncover areas for improvement that could help you optimize operations and boost profitability.

Conclusion: Understanding Your Ratios in Context

By comparing your financial ratios to industry standards, you can gain valuable insights into how your business is performing. Regularly reviewing these ratios will help you stay on track, identify potential issues early, and make informed decisions about the future of your business. Industry benchmarks serve as a useful tool, but remember that each business is unique, and your financial strategy should reflect your individual goals and circumstances.

If you need help analyzing your business’s financial ratios or understanding how they compare to industry standards, feel free to reach out. I’m here to help you navigate your financial strategy and grow your business confidently! You can email me @ susan.ball5@aol.com

Know Your Financial Ratios: The Key to Understanding Your Business’s Profitability

Understanding your financial statements is crucial to managing your small business effectively. However, it’s just as important to analyze these statements to assess how your business is performing. One powerful tool to do this is financial ratios. These ratios can help you measure your business’s financial health and compare it to others in your industry.

Here’s an overview of key financial ratios every business owner should understand and know how to calculate.

What Are Financial Ratios?

Financial ratios are calculations that help business owners evaluate their financial performance. They allow you to measure things like liquidity, profitability, and leverage—giving you a clearer picture of your business’s financial health.

Measures of Liquidity:

Liquidity refers to how easily assets can be converted into cash to cover short-term obligations. To maintain financial stability, it’s essential for a business to have sufficient liquidity.

Current Ratio: The current ratio measures a company’s ability to meet short-term liabilities using short-term assets.

Formula: Current Ratio = Current Assets / Current Liabilities

A ratio greater than 1 indicates that the company can pay its short-term obligations using its assets. A higher ratio means more liquidity.

Quick Ratio: The quick ratio is another liquidity measure, but it excludes inventory from current assets, recognizing that inventory may take longer to sell and convert into cash.

Formula: Quick Ratio = (Current Assets – Inventory) / Current Liabilities

Inventory Turnover Ratio: This ratio measures how often a company sells and replaces its inventory during a period. A higher turnover suggests that inventory is being sold quickly. Inventory turnover ratios vary greatly from one industry to another. Businesses whose inventory is perishable must turn over their inventory in a few days, whereas businesses whose products have long lives turn over their inventory just a few times a year.

Formula: Inventory Turnover Ratio = Cost of Goods Sold / Average Inventory

Measures of Profitability:

Gross Profit: Gross profit represents the revenue that remains after subtracting the cost of goods sold (COGS). It’s essential for understanding how much revenue is available to cover operating expenses.

Formula: Gross Profit = Revenues – Cost of Goods Sold

Gross Profit Margin: The gross profit margin shows the percentage of revenue available to cover operating expenses.

Formula: Gross Profit Margin = (Revenues – COGS) / Revenues

A higher gross profit margin indicates a more efficient business model.

Net Profit: Net profit is the remaining revenue after subtracting all expenses, taxes, and interest. It represents the business’s overall profitability.

Formula: Net Profit = Revenues – COGS – All Business Expenses

Net Profit Margin: The net profit margin calculates what percentage of revenue remains as profit after all expenses are paid.

Formula: Net Profit Margin = Net Profit / Revenues

Operating Profit (EBITDA): After taking out the cost of goods sold and paying all operating expenses you are left with the Operating Profit. It measures the funds available to meet obligations, such as loan payments and taxes. It’s also known as EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization).

Formula: Operating Profit = EBITDA = Gross Profit – Operating Expenses

Return on Assets (ROA): The return on assets ratio measures how efficiently a business is using its assets to generate profit.

Formula: Return on Assets = Net Profit / Total Assets

Return on Equity (ROE): The return on equity ratio shows how much profit a company generates with the money invested by its shareholders.

Formula: Return on Equity (ROE) = Net Profit / Shareholder’s Equity

Leverage Ratios:

Leverage ratios indicate the degree to which a company is financing its operations through debt, which is vital for evaluating financial risk.

Debt-to-Equity Ratio: The debt-to-equity ratio compares a company’s total debt to its total equity.

Formula: Debt-to-Equity Ratio = Total Debt / Total Equity

Interest Coverage Ratio: The interest coverage ratio measures a company’s ability to meet interest payments.

Formula: Interest Coverage Ratio = EBIT / Interest Expense

Debt Service Coverage Ratio: This ratio measures a business’s ability to cover its debt obligations (principal and interest payments).

Formula: Debt Service Coverage Ratio = Net Operating Income / (Principal + Interest Due)

A ratio of 2.5 to 3.0 or higher is often seen as a healthy benchmark by lenders.

How to Interpret Financial Ratios

Now that you understand the basic financial ratios, it’s essential to interpret what they mean. Some ratios, such as the debt service coverage ratio, are fairly standard across industries. Other ratios, such as inventory turnover or profit margins, can vary significantly between different industries.

In our next blog post, we’ll dive deeper into how to access industry data to benchmark your ratios and what variances in your ratios mean for your business’s performance.

Conclusion: Why Financial Ratios Matter

Understanding and calculating financial ratios is crucial for small business owners who want to assess their financial health. These ratios provide valuable insights into liquidity, profitability, and financial risk. By regularly tracking these ratios, you can make informed decisions about your business’s financial strategy and growth.

If you have any questions about how to calculate or interpret your business’s financial ratios, feel free to reach out in the comments below or email me at susan.ball5@aol.com. I’m here to help you manage your business finances with confidence!