Financial Ratios: Simple Tools For Better Business Decisions

Great products, marketing, sales, teams and operations certainly play a role in your success – but one thing is equally vital to sustained growth … understanding your numbers!

No you don’t need to be an accountant and well versed on debits, credits and a lot of financial information. But you do need to have a working knowledge of your income statement (profit & loss), balance sheet and cash flow statement – along with some financial ratios to help you make better decisions, identify trends and uncover opportunities!

There are a variety of financial ratios used to evaluate activity, efficiency, investments, leverage, liquidity and profitability. Relax, I’m not going to bore you with all of them! But here are a few common ones I use often with clients, just to get you started.

Current Ratio (also known as Liquidity and Working Capital Ratio)

This ratio measures your ability to pay short-term obligations. In other words, do you have enough current assets to cover your current debts or liabilities — current being the operative word here. Current assets include cash plus receivables and inventory that can be turned into cash within a year. Current liabilities are those debts that are due within a year, such as supplier payables, credit cards, payroll taxes, etc.

The current ratio can give you a sense of efficiency and measures your ability to turn products or services into cash. Long inventory turnover cycles, poor collection of receivables and inefficient use of labor can contribute to liquidity problems and poor current ratios.

The ratio calculation is Current Assets / Current Liabilities. The higher the ratio, the more capable the company is of paying its obligations. Anything below 1 indicates a negative current ratio, suggesting you may have problems meeting short-term debt obligations. While it is best to compare ratios by industry, a ratio between 1.2 and 2.0 is normally sufficient.

Here’s an example: Company XYZ has current assets of $23,400 and current liabilities of $17,300. Its current ratio is 1.35 ($23,400 / $17,300 = 1.35)

I also find trends helpful, so take a look at your quarterly balance sheet for the past few quarters and do the calculation. Are the ratios up, down or relatively the same? Why?

Here are some ways to improve this ratio for your business:

  • Collect on past due receivables – and grant credit wisely!
  • Accept credit card or online payments from your customers – make it easy and convenient
  • Use a system for billing – be consistent, be timely, be accurate
  • Have a system for collections – a series of scripts, emails and letters helps – be persistent.
  • Manage inventory – buy ‘just in time’ and get rid of obsolete stuff
  • Schedule deliveries / service efficiently to manage labor costs

Gross Profit Margin Ratio

This ratio shows your company’s financial health after Cost of Sales or Goods Sold are deducted from your Revenue (Sales). It measures your pricing strategy and operating efficiency. Your gross profit represents what is left to pay fixed expenses (like rent, insurance, administration,) along with owner’s compensation and future savings or investments.

Gross Profit Margin is (Revenue – COGS) / Revenue

Here’s an example. Company XYZ earned $5 million in sales while incurring $3 million in COGS related expenses, so the gross profit margin is 40%. ($5M – $3M) / $5 M. That means for every $1 earned in sales, the company has 40 cents in gross profit to apply to other expenses and future savings.

This ratio is a common benchmark used to compare a company with its competition. Higher efficiency and greater uniqueness (premium pricing) typically translates into higher gross profit margins. Optimum profit margins vary by industry, and are available through industry associations, online services and your local library.

Return on Investment Ratio

ROI is a performance measure used to evaluate the efficiency and/or profitability of an investment for comparison with other investment options.

Many are familiar with ROI as it relates to financial investments, such as stocks and bonds and real estate. But as business owners, this metrics is used to evaluate a variety of investments – equipment, hiring, education/training, and marketing to name just a few. And yes, marketing is an investment!

ROI is calculated as follow:

Gain From Investment – Cost of Investment / Cost of Investment = Return on Investment

Here’s an example. Company XYZ invests $1,500 on a new marketing program. They anticipate the effort will produce $7,000 in additional revenue. So the projected ROI is $7,000 – $1,500 / $1,500 = 3.66 or 366%.

One caution when it comes to comparison of ROI ratios. Be clear on what is included in the Gain and Cost elements and be consistent with your comparisons. In the above example, we defined the gain from investment as revenue, a common practice; but we could just as easily defined the gain on investment as gross profit from the additional revenue.

Here’s an example to demonstrate the difference. In the above example, assume that Company XYZ operates with a 40% gross profit margin. Then the gain on investment would be additional revenue ($7000) x gross profit margin (40%) or $2,800. The projected ROI is now $2,800 – $1,500 / $1,500 = .867 or 86.7%

There is no right or wrong method – just be consistent in your approach. When getting ROI ratio from others, be clear on the gain and cost elements they used!

There’s an old saying when it comes to measures of success – What we measure, we can improve. Start using these tools in your business – and put yourself on a path to better decisions and better results!

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