These essential financial
ratios give you a powerful insight into how your business
is doing.
Financial ratios help you to measure where your business stands, where it’s
been and where it’s heading. They also help you measure yourself against
industry benchmarks, and see how you’re tracking against your business
plans.
There are plenty of ratios to choose from. Here are our top five.
Gross profit
margin
Your gross profit margin tells you the average gross profit on each
dollar of sales before operating expenses. The equation is
simple:
Your gross profit margin will depend on the industry you’re in, so it’s
important to measure yourself against industry benchmarks. It’s an essential
starting point for assessing the profitability of each product — but it still
doesn’t tell you whether your business is making a profit over all. For that
you need the net profit margin.
Net profit
margin
Your net profit margin is the percentage profit your business makes for
every dollar of revenue – whether you’re making a profit after covering
all of your costs.
Again, your target net profit margin will be at least partly determined by
your industry. Some retailers, for example, run high-volume, low-margin
businesses, while others sell a small number of expensive items with plenty of
margin built in.
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Current ratio
You’re making profitable sales but are they enough to cover short term
liabilities? To answer that, you need the current ratio. It helps to measure
the solvency of your business by comparing your current assets (like unpaid
invoices) to your current liabilities (unpaid bills and the like):
As a rule of thumb, you want your current ratio to be 2 or more. In other
words, your assets should be at least double your liabilities, meaning you have
plenty of capacity to meet them.
If sales are growing and you have a short operating cycle, a lower number
may be OK. But if you have a long operating cycle, you might want your current
ratio to be higher, to make sure liabilities don’t get out of control.
Inventory
turnover
If you have trading stock, then inventory turnover is an incredibly
useful number. It shows you how many times your business’ inventory is sold and
replaced over a particular period:
So, if you’ve spent $200,000 buying stock over the year, and you keep an
average of $20,000 worth of stock on hand, then your inventory turnover is 10
times a year.
Inventory turnover varies by industry but as a rule of thumb the higher it
is the better. A low turnover indicates you have a lot of money tied up in
stock for long periods of time, which is not good for cash flow. Too high a
figure could indicate you’re not keeping enough stock on hand!
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Return on owner’s equity
Return on owner’s equity compares your net business income to the equity
you’ve invested in the business. It reveals how much you’re making from your
investment:
So if you’ve invested $200,000 of your own money in the business, but it’s
generating a net income of $100,000 a year, then your return on owner’s equity
is 50%.
This ratio is a great way to compare what you’ve earned from your business
to what you might have earned from another investment. If you’re just starting
up, it might not be as high as you’d like, but it tends to increase over time
as your business grows, especially if your personal investment remains the
same.
Where to find out more
