Let’s face it—unless you’re an accountant or bookkeeper, numbers aren’t always the most exciting part of running a business. Honestly, though, understanding your financial health is like having a GPS for success, keeping you on track and helping you avoid costly detours.
Financial ratios are your secret weapon. They break down the nitty-gritty of your business performance, showing you what’s working, what’s not, and where you can improve.
So, grab a coffee (or a glass of wine), and let me explain clearly what you need to understand about your financials…
Profitability Ratios: Show Me the Money
Profitability ratios measure how effectively your business is turning effort into income. If you’ve been following my blog or socials, you’ll know I’m absolutely obsessed with profitability over everything else. I’m not a fan of the “grow your turnover first, fix profitability later” strategy—it’s a recipe for unnecessary headaches. Instead, the goal should always be to build a business that consistently turns a profit, even during lean times. That strong foundation is the key to sustainable, stress-free growth.
(1) Gross Profit Margin
Think of this as your business’s glow-up—it shows how much profit you keep after covering the DIRECT cost of your products or services.
Formula: (Sales – Cost of Goods Sold) ÷ Sales
Target: Aim high! A gross profit margin above 50% is often the sweet spot for small businesses (but check what’s typical for your industry).
How to improve: Up your pricing game, negotiate better deals with suppliers, or get creative with cost-saving hacks—without compromising quality, of course!
(2) Net Profit Margin
This one’s the bottom line—it tells you how much of your revenue actually sticks around after all the bills are paid.
Formula: Net Profits After Taxes ÷ Sales
Target: 10% or more is a solid goal for small businesses, but again it depends on your industry.
How to improve: Boost sales, trim unnecessary expenses, and streamline operations to keep more dollars in your pocket.
Liquidity Ratios: Keeping the Lights On
Liquidity ratios are your safety net, showing whether your business can handle short-term obligations without breaking a sweat.
(1) Quick Ratio (Acid Test)
This is the no-frills test of your financial health—it looks at how quickly you can cover liabilities with your most liquid assets.
Formula: (Cash & Cash Equivalents + Marketable Securities + Accounts Receivable) ÷ Current Liabilities
Target: A ratio above 1 means you’re in the safe zone.
How to improve: Speed up those invoices, stash some extra cash for a rainy day, or cut down on short-term liabilities.
(2) Current Ratio
Think of this as your “ready for anything” metre—it shows whether you have enough assets to cover your liabilities.
Formula: Total Current Assets ÷ Total Current Liabilities
Target: A 2:1 ratio is ideal, but this can vary depending on your industry.
How to improve: Get better at managing inventory, keep the cash flowing, or trim down liabilities.
Efficiency Ratios: Work Smarter, Not Harder
Efficiency ratios are all about making the most of what you have.
(1) Inventory Turnover Ratio
This ratio tells you how quickly you’re moving inventory—because nobody wants stock gathering dust.
Formula: Cost of Goods Sold ÷ Average Inventory
Target: The higher, the better, but it depends on your industry.
How to improve: Get strategic with inventory management, focus on your best-sellers, or refine your sales approach.
(2) Leverage Ratios: Balancing Act
Leverage ratios show how much you’re relying on borrowed money versus what you’ve put in.
(3) Debt-to-Equity Ratio
This ratio is like your financial mixologist—it balances what’s financed through debt versus equity.
Formula: Total Liabilities ÷ Shareholders’ Equity
Target: A ratio around 2 or 2.5 is usually a good balance.
How to improve: Pay down debt, increase profits, or bring in investors to strengthen your equity.
To improve your ratios:
- Get savvy with financial management
- Keep your pricing sharp and competitive
- Streamline your inventory
- Boost your cash flow by staying on top of invoices
- Control costs without cutting corners
- And, when in doubt, don’t hesitate to get in touch with our team
By getting familiar with these key ratios and making them part of your regular business check-ups, you’ll be setting yourself up for long-term success.
At Freshwater Taxation, we now provide FREE monthly financial reports to all small business clients. Don’t hesitate to let us know if you’d like help diving into your numbers or setting up a system to make it all easier. We’re here to help you every step of the way.
