How to Understand and Improve Financial Ratios for Your Small Business

When a business is looking to benchmark its performance and develop key performance indicators for growth, consider taking the perspective of a lender.

Smart lenders look closely at the financial performance of a business, so you might ask the question: “Would my company receive the credit it needs to grow?” Encouraging business people to answer this question—even if they don’t need a loan—helps to identify weaknesses and make improvements.

Many private companies find it challenging to access financial resources for growth when lenders are cautious and facing pressure to avoid risky loans. In addition to improving cash levels and earnings, cutting expenses, and reducing debt, companies seeking credit should consider focusing on improving key financial metrics that can best predict default.

The 5 financial metrics your business should be improving

The five financial statement ratios that are related to default analysis and are often used by creditors to assess the company’s financial performance include:

• Cash to assets
• EBITDA to assets
• Debt service coverage ratio
• Liabilities to assets
• Net income to sales

Improving these key financial metrics can enhance your appeal to banks and other potential creditors. The good news is that you’ll have access to the data necessary to explore these ratios directly within your financial plan and forecasts. In fact, if you have access to planning software, Like LivePlan, you can even look into setting up financial dashboards. This can help you keep an eye on ratios and other financial data points more easily. 

Now, why should you care about these metrics specifically? Let’s explore how these metrics tell the story of your business. We’ll also tap into expert insights from Michael W. McNeilly, director of advisory services, and analyst Libby Bierman, from Abrigo—for their advice on improving these metrics. 

1. Cash-assets ratio

The cash-assets ratio is the current value of cash and cash equivalents divided by your liabilities. It’s a key measure of liquidity and one of several coverage ratios that tell creditors about a company’s likelihood of default. It provides an indication of how much flexibility a business has to utilize cash or to access liquid accounts in order to make good investments or cover expenses.

A company with its cash tied up in accounts receivable and inventory (a low ratio of cash-assets) might not have enough cash to keep the lights on, much less to ramp up production if sales accelerate. Cash is king, and you want to be sure that you have enough to cover liabilities and hold a strong cash runway should a crisis occur. 

For any banks or investors, this helps them understand the risk of investing in your business. If all of your cash is tied up into things that can’t easily be liquidated, they may be less likely to invest. On the flip side, having a neutral or high-value ratio can display that whatever financing you receive will be used for growth initiatives rather than handling current debt. 

How to improve your cash-assets ratio

A key way to boost a business’s cash-assets ratio is to boost its cash position, and there are numerous approaches to do this.

Lower accounts receivable

One way to boost your cash position is by lowering accounts receivable. This can start with an examination of the company’s credit policy. Ensuring that its credit practices are actually increasing the business’s revenue and income rather than simply draining its cash. Some businesses extend different credit terms to different customers based on creditworthiness and the overall relationship involved, according to McNeilly.

Lower accounts payable

Accounts payable is another line in the financial statement that can provide opportunities for improving this ratio. Avoid pre-paying expenses or paying bills earlier than the terms agreed upon so that the funds are kept inside the business (and perhaps earning interest) as long as possible.

Inventory management

Another way to ensure the cash-assets ratio is as high as possible is to carefully manage inventory. Take a look at your inventory and focus on selling your slow-moving items first. Then explore leveraging a system that allows the business to order only when needed so that cash is not tied up in merchandise. 

TLDR — improve your cash-assets ratio by:

• Lowering accounts receivable and limiting on-credit purchases
• Monitoring invoicing procedures to limit late collections
• Avoiding pre-paying expenses
• Selling off slow-moving inventory

2. EBITDA-assets ratio

EBITDA, or earnings before interest, taxes, depreciation, and amortization, is often used to measure the ability to generate income. This is your operating income, and it can help you find things like your profit margin by dividing by revenue. 

It’s widely used as a substitute for pre-interest, pre-tax cash flow from operations. Basically, it tells you what you have left over after subtracting expenses and can tell you how profitable you really are.

Comparing EBITDA to a company’s assets helps show efficiency. How much income, or cash, a company can generate from its equipment, property, and other assets.

How to improve your EBITDA-assets ratio

Focus on the numerator in this equation. Boosting EBITDA typically involves either raising revenues, without a substantial increase in expenses, or strictly cutting expenses.

Raising revenues can involve better planning, or it can involve improving business offerings by gaining insight from customers through methods of customer input. “Reducing friction points—learning curves, waiting periods, paperwork, delivery charges, and so on—in the customer experience will encourage them to use and recommend your business more often,” says Bierman.

However it’s done, increasing sales volume allows for better coverage of fixed costs, which can lead to higher profitability. Cutting expenses is often the focus of efforts to boost EBITDA, because those savings may fall straight to the bottom line. “If the business is not continually reviewing and updating its existing and potential vendor lists, it may overspend on supplies or inventory,” McNeilly says.

To cut back on spending and free up more cash, start by reviewing basic expenses. Your insurance deductible, telephone, internet, and equipment leasing are all potential examples. Businesses that are willing to negotiate with their service and goods providers may be able to trim some expenses, improving EBITDA.

Sometimes it helps to benchmark the financial performance of the company to that of peers to guide efforts to improve EBITDA to assets. Doing so can help identify areas where a business lags—in net profit margin, for example, or inventory turnover.

TLDR—improve your EBITDA-assets ratio by:

• Increasing sales volume and revenue through customer suggestions and sales planning
• Cutting supply or inventory expenses through vendor selection and contract negotiations
• Reviewing overhead expenses such as telephone or equipment
• Benchmarking the company to its peers and identifying areas to improve

3. Debt service coverage ratio

The debt service coverage ratio can be found by dividing EBITDA by a current portion of long-term debt and interest expense. Basically, this is just a measurement of your business’s ability to pay current debt obligations based on your cash position and operating income. It is an extremely important metric for predicting if you’ll default on a loan. 

How to improve your debt service coverage ratio

In addition to improving the EBITDA-assets ratio, a business can also focus on eliminating debt and interest expenses.

One effective way of tackling the debt/interest side of this ratio is to cut expenses. “Sell things that can boost cash, such as unproductive assets,” advises Bierman. “These are assets that are not contributing sufficiently to the generation of income and cash flow, possibly because they are under-utilized. Use the proceeds to pay off the principal on your debt.”

Similarly, small decreases in overhead can typically yield large cash savings over time. The impact of those savings is compounded when they are used to repay the principal. Potentially lowering debt payments and also interest expenses.

TLDR—improve your debt service coverage ratio by:

• Focusing on increasing EBITDA, using any of the recommendations from the previous section
• Considering refinancing to lower interest rates and therefore lowering interest expense
• Using available cash to pay off more principal, making interest payments smaller
• Reducing opportunities for business fraud within the company, which can inflate the costs of sales

4. Liabilities-assets ratio

The liabilities-assets ratio shows how much of a company’s assets are financed through debt, as opposed to financed through profits from the business. Higher ratios of liabilities to assets often result in higher interest rates on debt, reflecting the lender’s view that the borrower is more of a risk. Banks and commercial lenders want this ratio to be as low as possible, but generally below 1:1.

Most financing institutions advise lenders to seek low ratios because they don’t want a business to be struggling to repay its debt. The more debt you have, the more of your cash flow you’ve committed to supporting that debt. Creditors understandably place an emphasis on this metric when reviewing a potential borrower. If a business doesn’t have any debt, they’re not very likely to go into default—it’s virtually impossible.

How to improve your liabilities-assets ratio

Improving this ratio is all about reducing debt. This means making the highest possible debt payment each month, especially on small-business credit cards. In addition to hurting a business’s liabilities-assets ratio, the high balances that can quickly accumulate on credit cards can cost a business a lot of money in interest charges. 

TLDR—improve your liabilities-assets ratio by:

• Aiming to keep this ratio at or lower than 1:1
• Making the highest possible monthly payment toward credit card debt
• Reducing total debt by paying off more principal

5. Net income-sales ratio

The net income-sales ratio is a fundamental measure of how profitable your business is. It is found by dividing net income by total sales.

How to improve your net income-sales ratio

To improve the income to sales ratio, increasing profitability is key.

There are three possible fixes for low profitability. One option—cutting operating expenses—which can be more of a short-term fix. Two of the fixes—increasing profitable sales and lowering production costs—take time to identify and implement.

Lowering production costs often involves finding ways to get raw materials or key services more cheaply or to use less of them. Or it can mean identifying new, more efficient methods of producing a good or providing a service.

To increase profitable sales, you have to find new markets or new prospects, work through the sales cycle, and so on. Lowering the cost of goods sold typically involves studying the production process, finding inefficiencies, and implementing changes. Converting browsers into buyers by scheduling operational duties (such as receiving) to take place at a time customers aren’t likely to need assistance is one way to optimize sales.

TLDR—improve your net income-sales ratio by:

• Focusing on reducing overhead expenses even if they’re one-time savings
• Increase sales volume to spread fixed costs further, to improve profitability
• Seeking advice from customers as to how the company can optimize their offering for the customer
• Finding a new market, potentially boosting sales

Improving financial performance is essential

Even if your business isn’t seeking a loan right now, improving these financial statement ratios is essential for improvement.

By monitoring these key financial metrics, small business owners will see increased performance within their company. Increased revenues and profits, reduced interest payments and overhead expenses, and greater attention to customer feedback overall. 

Try to tie the exploration of these ratios into your monthly plan review meeting to ensure you’re keeping track. And again, you can save time and avoid mistakes by leveraging a business dashboard that keeps all of your financials in one place.