Financial ratios: 4 of the best ways to assess your business
If it’s time to take a more in-depth look at your financial structure, this will help:
You might be ready to review your financial ratios for any number of reasons; a business expansion, potential investor, or a nagging sense that you’re borrowing money a bit too regularly than you’d like.
Whatever the reason – or nature of your business – measuring financial ratios will give you valuable insight. It’s a great way to analyse your financial health and identify how to improve it.
Why are ratios so helpful?
They’re used to make comparisons between different aspects of a company’s performance or how the company stacks up within a particular industry or region.
They reveal very basic information such as whether you’ve accumulated too much debt, stockpiled too much inventory, or are not collecting payments fast enough.
Which are the most important ratios to measure?
There are many different potential financial ratios (sometimes also called KPIs) that you could measure – and I’m always happy to talk through your unique business requirements to pinpoint the most helpful for you.
But in the interest of brevity and highlighting the most popular and effective for our clients, here are four to focus on today:
1. Gross Profit Margin
Fundamentally, this is an indication of how efficiently your business operates. The way it’s calculated is you take your gross profit (which is turnover less direct costs or cost of sales) you then divide that figure back into your turnover to give you a percentage. This percentage is your gross profit margin.
2. Net Profit Margin
A measure to show how profitable your business is, and therefore how well rewarded the business owner can be. The way to measure this is your net profit divided by the turnover for any given period and represented as a percentage.
3. Percentage of turnover spent on your team
If your business has a large team, your team costs will be part of your direct costs. These may increase as your business grows.
A classic scenario is this; a business owner starts a business based on something they’re passionate about, that they do well. They get increasing demand and start to employ more people.
As the business grows everything’s fine until it reaches a tipping point. At that point, the business owner will find they have a team that they trust, value, and care for. And then that team suddenly finds themselves perhaps a little bit overworked, under pressure, or under stress.
Often, the knee-jerk reaction is for the team to say “We need more people. We’re struggling!”
And the business owner, trusting their team, responds by hiring more people.
But this can easily get out of control. You suddenly find that you’re not making so much profit because there are so many people around – and actually there might be people who are slipping under the radar that are not productive and not doing what they need to be doing.
This is a very common trend that I see in small businesses who are going through a growth spurt and is definitely one to watch when it comes to your team costs.
4, Cash Flow
If you have concerns about your current cash flow, you’ll want to measure the following:
Debtor days – the average time it takes for your customers to pay an invoice
Creditor days – the average amount of days it takes you to pay your suppliers
Current ratio – this is a ratio of your current assets to current liabilities and demonstrates how liquid your business is (that is how quickly you can get on top of cash when and where you need it)
This is just for starters!
Knowing your financial ratios is a great starting point. But how do you take this information and put it to work for your business?
I’ll be happy to help you dig deeper.
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