Financial Ratios Every Owner Should Monitor

Ratios Tell You What Raw Numbers Cannot

Your P&L says you made $80,000 in net income. Great. But is that good? Compared to what? $80,000 on $500,000 in revenue is a 16% net margin — strong for most service businesses. $80,000 on $2,000,000 in revenue is 4% — razor thin.

Financial ratios provide context. They let you compare your performance over time, benchmark against your industry, and spot problems before they become crises. Here are the ratios every owner should know.

Profitability Ratios

Gross Profit Margin

Formula: (Revenue - COGS) / Revenue

This tells you how much you keep from each dollar of revenue after paying direct costs. If your gross margin is 40%, you keep 40 cents of every dollar to cover overhead and profit.

Benchmarks vary by industry:

• Service businesses: 50% to 70%
• Contractors: 25% to 45%
• Retail: 25% to 50%

Watch for: Declining gross margin over time. This means your direct costs are rising faster than your prices — a margin erosion problem.

Net Profit Margin

Formula: Net Income / Revenue

The bottom line percentage. After all expenses, taxes, and interest, what percentage of revenue do you keep?

General benchmarks:

• 5% is surviving
• 10% is healthy
• 15%+ is strong

Watch for: Revenue growing while net margin shrinks. That means expenses are outpacing growth.

Operating Profit Margin

Formula: Operating Income / Revenue

This strips out interest and taxes to show how well your core business operations perform, regardless of financing decisions.

Liquidity Ratios

Current Ratio

Formula: Current Assets / Current Liabilities

Can you pay your short-term obligations? A ratio of 1.0 means you can barely cover them. Below 1.0 means you cannot.

• Below 1.0: Danger zone. You may not be able to cover short-term debts.
• 1.0 to 1.5: Tight but manageable.
• 1.5 to 3.0: Healthy.
• Above 3.0: Very conservative. You might be sitting on too much cash that could be invested in growth.

Quick Ratio (Acid Test)

Formula: (Current Assets - Inventory) / Current Liabilities

Same concept but removes inventory, which may not be quickly convertible to cash. More relevant for businesses that carry significant inventory.

Efficiency Ratios

Days Sales Outstanding (DSO)

Formula: (Accounts Receivable / Total Credit Sales) x Number of Days in Period

How long does it take to collect payment? Lower is better.

• Under 30 days: Excellent
• 30 to 45 days: Average
• Over 45 days: You have a collection problem

Track monthly and look at the trend. Rising DSO means customers are taking longer to pay.

Accounts Payable Turnover

Formula: Total Purchases / Average Accounts Payable

How quickly are you paying your vendors? This should align with your payment terms. If you have Net 30 terms but your turnover suggests you are paying in 15 days, you are leaving free float on the table.

Inventory Turnover

Formula: COGS / Average Inventory

How many times per year you sell through your inventory. Higher turnover means less cash tied up in stock.

• Low turnover: Too much inventory sitting on shelves. Cash is trapped.
• High turnover: Efficient, but make sure you are not running out of stock.

Leverage Ratios

Debt-to-Equity Ratio

Formula: Total Liabilities / Owner's Equity

How much debt are you using relative to your own investment? A ratio of 1.0 means equal debt and equity. Above 2.0 gets risky for most small businesses.

Watch for: This ratio climbing over time. It means you are increasingly reliant on debt to fund operations or growth.

Debt Service Coverage Ratio

Formula: Net Operating Income / Total Debt Service (principal + interest payments)

Can you cover your debt payments from operating income? Lenders look at this closely.

• Below 1.0: You cannot cover your debt payments from operations. Serious problem.
• 1.0 to 1.25: Tight.
• Above 1.25: Comfortable.

How to Use These Ratios

Track Monthly

Calculate your key ratios at least monthly. Put them in a simple dashboard or spreadsheet. The power is in the trend, not any single data point.

Compare to Industry Benchmarks

Industry benchmarks are available through SCORE, the SBA, and trade associations. Know where you stand relative to peers.

Set Targets

Do not just monitor ratios — set targets. If your gross margin is 35% and the industry average is 42%, create a plan to close that gap through pricing adjustments or cost control.

Investigate Anomalies

If a ratio changes significantly month over month, dig in. A sudden drop in current ratio might mean you just made a large purchase, or it might mean receivables are slipping.

The Dashboard

At minimum, track these monthly:

| Ratio | Current | Last Month | Target | |-------|---------|------------|--------| | Gross Margin | 38% | 40% | 42% | | Net Margin | 11% | 12% | 12% | | Current Ratio | 1.8 | 1.9 | 2.0 | | DSO | 42 days | 38 days | 30 days | | Debt-to-Equity | 0.8 | 0.7 | < 1.0 |

This simple table gives you a snapshot of business health in under a minute.

The Bottom Line

You do not need to be a financial analyst, but you need to think like one. Ratios are the vital signs of your business. Monitor them regularly, know what healthy looks like, and act quickly when they move in the wrong direction.