Success is more than an anecdotal concept you share with close friends and family. Simply saying, “My company is successful,” does not make it so. There are metrics to measure business prosperity, including liquidity, profitability, and returns. This article breaks down five key financial ratios your business can use to measure success.
1: Current Ratio
Your company’s liquidity is a key indicator of financial health. The term liquidity is used to describe how easily you can turn your company’s current assets into cash. That cash, after you subtract your current liabilities, is your “working capital.” You can measure it by calculating your company’s “current ratio.” Here’s the formula:
Current Assets / Current Liabilities = Current Ratio
The formula to calculate working capital seems simple, but it’s important to understand what the term “current” means. Current assets include cash, cash equivalents, and assets that can be converted to cash within one year. Those include accounts receivable, pre-paid liabilities, stock inventories, and marketable securities. Current liabilities are bills that are due within one year.
If your company has $10 million in current assets and $5 million in current liabilities, your current ratio is 2.0. A good current ratio is anywhere between 1.5 and 3.0. Anything lower suggests you need to increase revenue or cut expenses. Anything higher is a sign that you need to invest more of your liquidity into growth and expansion.
2: Quick Ratio
The quick ratio is the current ratio minus prepaid expenses and inventory. It incorporates only cash, cash equivalents, and assets that can be converted to cash immediately. This ratio is typically used as a quick check to see if a company can pay its bills. You may also hear the quick ratio described as an “acid test” for business liquidity. Here’s the formula:
Quick Assets / Current Liabilities = Quick Ratio
Assets used in the quick ratio are known as “quick assets.” They include cash (obviously), cash equivalents, marketable securities, and net accounts receivable. Inventory takes time to sell. Prepaid expenses can’t be used to pay other bills. Neither is used in the quick ratio. The number you’re looking for is at least 1, preferably 1.5.
Using the example for the first metric above, assume that $2.5 million of those current assets are not “quick assets.” That changes the equation. It’s now $7.5 million / $5.0 million, a quick ratio of 1.5. Congratulations. You can afford to pay your bills and you have a few dollars left over to cover unexpected emergencies and rising costs.
3: Earnings Per Share (EPS)
Earnings per share tells shareholders if they’ve made any money. To calculate EPS, you divide your net income by the “weighted average” of outstanding common shares. The weighted average is calculated by subtracting preferred dividends (PD) from net income (NI) and dividing that by the average outstanding common shares (AOCS). Here’s the formula:
(NI – PD) / AOCS = EPS
This formula uses an average because companies may issue or buy back stocks. Corporate buybacks can improve EPS before a merger or acquisition, inflating the value of the company stock for the sellers. Public companies should monitor their EPS and their stock value to ensure investors and shareholders are getting good returns.
There isn’t a “good” range for EPS, but negative numbers are definitely bad. They indicate that your company is overleveraged with too many shares of common stock outstanding. They could also be a sign that your company is struggling financially. You may want to contact our accounting firm to do a full review of your income and expenses.
4: Price-to-Earnings ratio (P/E)
You’ll need to do the earnings per share (EPS) calculation before you can calculate your price-to-earnings (P/E) ratio because it’s one of the variables in the equation. Investors use P/E to assess a stock’s earnings potential before buying it, so this is a critical metric if you’re a publicly traded company. Here’s the formula used to calculate your P/E ratio:
Current Stock Price / Earnings Per Share = Price to Earnings Ratio
Stock prices are fluid, so the P/E ratio won’t be constant. Most financial analysts use the average EPS for a specific time period and the closing price of the stock on the last day of that period to calculate a P/E ratio for publication. If your company is listed on a public stock exchange, your P/E ratio should be published with your listing.
When a company has zero or negative earnings, the P/E ratio will show as “not applicable.” Investors should look for a P/E ratio of 20 to 25 when researching stocks to buy. Apple (AAPL), one of the top-performing stocks on Wall Street, had a 2023 P/E ratio of 31.16 with a 2024 estimate of 29.08. Apple is considered a “good” investment.
5: Debt-to-Equity Ratio (D/E)
Debt is one of the financial tools your company can use to grow and expand your business. When employed responsibly, debt can be good. When used irresponsibly, it can be a force that takes down your company. The debt-to-equity ratio can be used to determine which category your debt falls in. Take a look at the formula below:
Total Liabilities / Total Shareholders’ Equity = Debt-to-Equity Ratio
Unlike the previous ratios we’ve covered today, lower numbers are better when evaluating debt-to-equity. D/E ratios of 1.0 or lower are considered safe. Anything over 2.0 is considered risky and may stop you from being able to acquire new credit for your company. Keep that in mind before you submit your next business loan or credit card application. The numbers you need to calculate debt-to-equity can be found on your company’s balance sheet.
If you need help with this or any other ratios listed in this article, contact D&M Accounting today and ask us about our business accounting services. You can use the contact tab at the top of this page or call 262-253-9955 to schedule a consultation.
