How to measure business performance using Financial Ratios
As a small business owner, how do you know how your business is performing? Do you know whether it is growing or slowing? Are you getting better at paying bills or getting worse at collecting debt?
Fortunately there’s a way to find out how your business is performing by using financial ratios.
Financial ratios are simply the relationship between one piece of financial information and another and are used for comparison purposes. These financial ratios are the result of dividing one account balance or financial measurement with another. Most commonly these measurements or account balances are found in the company’s financial statements: the Income Statement, Cash Flow Statement or Balance Sheet.
Financial ratios can provide the small business owner with a valuable tool kit to measure progress over time and to track performance against goals. Keep in mind though, that financial ratios are just indicators and are time-sensitive. They only a present a picture of the business at the time that the underlying financial information was prepared.
Financial ratios enable business owners to track the relationships between items and measure that relationship. They are simple to calculate and easy to use. Financial ratios provide business owners with insight about what is happening in their business which might not otherwise appear in the financial statements. The good thing about ratios is they can really pinpoint and draw attention to areas that need more focus.
Financial ratios can be used to track efficiency, effectiveness, profitability and return on investment and anything else in between.
The key ratios I like to get started with for my clients are what we call the net profit margin and cash collection and payment ratios, profitability ratios. Profitability ratios provide information about the small business’s profitability.
The two ratios that I like to use to measure the quality of the profits over time are what accountants like me call the Gross Profit Margin and the Net Profit Margin. Both of which are expressed as a percentage of sales.
The gross profit margin, is simply the subtraction of the direct costs of delivering your cost or service from your revenues or sales and then dividing that by the total sales revenue.
If we assume that the number is positive this is positive then great.
However, on its own, this number is meaningless.
Tracked over time, this financial ratio shows you whether you are selling your products or services for a high enough price or your direct costs of selling are too high. Comparing this financial ratio over a period of time will give you an indicator of where things are going in your small business. If your margin is reducing and your sales price remains unchanged, then you need to look at either increasing your prices or reducing your costs.
I also calculate this financial ratio for net profit too. This Financial ratio is different to the Gross Profit ratio because it takes into account the total costs of running your business. Quite simply the total costs including your direct or indireet costs to sell your products or the service and subtracted that from your sales.
The number you get, is called the Net Profit.
You simply just divide the Net Profit number by your total sales. If you have strong gross profits but poor net profitability, then you’ve got a problem with your indirect operating expenses, for example your rent or interest payments are maybe too high.
Net profitability is simply net profit divided by total sales. What you’re looking for here is an increasing net profit or at the very least a stable net profit over time.
The second key ratio that I like to look at what accountants call The Quick ratio. Although it’s sometimes also called the Asset Test Ratio.
The Quick Ratio is simply the assets that you hold in your business that can be quickly turned into cash. For example cash, monies owed to you by others, any marketable investments like stocks, divided by the total current liabilities, in other words the amount of money that you owe to others.
For large companies anything between 1 and 1.1 would be a good result. However, I usually recommend to my clients that they are in the region of 1.1 to 1.25. The reason for the slightly higher margin is that, if anything, the Global Financial Crisis has shown that businesses with cash simply have more options.
Anything higher than 1.25 means that you may be holding too much cash or you are poor at collecting debt from your customers.
Related Post: How To Improve Cash Flow
If it’s lower than one to one, it may mean that you’re paying bills too early or that you simply owe too much. Tracked over time, this financial ratio will tell if your business is getting better or getting worse at collecting its debts or paying its suppliers too early.
Whilst financial ratios are useful tools for helping small business owners track progress in achieving goal have their limitation. For example ratios alone do not give all the information necessary to make a decision. Often a small business’s ability to weigh in with money may be solely made on the basis of the ratio.
Related Post: Actionable Metrics