How to Use Financial Ratios to Understand the Health of Your Business

How to Use Financial Ratios to Understand the Health of Your Business

Everything in business is relative. The numbers for your profits, sales, and net worth need to be compared with other components of your business for them to make sense. For instance, a $1 million net profit sounds great. But what if it took sales of $500 million to achieve those profits? That would be a modest performance indeed.

To help understand the relative significance of your financial numbers, analysts use financial ratios. These ratios compare various elements of your financial reports to see if the relationships between the numbers make sense based on prior experience in your industry.

Some of the common ratios and other calculations analysts perform include your company’s break-even point, current ratio, debt-to-equity ratio, return on investment, and return on equity. You may not need to calculate all of these. Depending on your industry, you may also find it useful to calculate various others, such as inventory turnover, a useful figure for many manufacturers and retailers. But ratios are highly useful tools for managing, and most are quick and easy to figure out. Becoming familiar with them and presenting the relevant ones in your plan will help you manage your company better and convince investors you are on the right track.

Quick Tip

There are four kinds of financial ratios: liquidity ratios like the current ratio, asset management ratios like the sales/receivable cycle, debt management ratios like the debt-to-equity ratio, and profitability ratios like return on investment.

Break-Even Point

One of the most important calculations you can make is figuring your break-even point. This is the point at which revenue equals costs. Another way to figure it is to say it’s the level of sales you need to get to for gross margin or gross profit to cover all your fixed expenses. Knowing your break-even point is important because when your sales are over this point, they begin to produce profits. When your sales are under this point, you’re still losing money. This information is handy for all kinds of things, from deciding how to price your product or service to figuring whether a new marketing campaign is worth the investment.

The process of figuring your break-even point is called break-even analysis. It may sound complicated, and if you were to watch an accountant figure your break-even point, it would seem like a lot of mumbo-jumbo. Accountants calculate figures with all sorts of arcane-sounding labels, such as variable cost percentage and semi-fixed expenses. These numbers may be strictly accurate, but given all the uncertainty there is with projecting your break-even point, there’s some question as to whether extra accuracy is worth all that much.

There is, however, a quicker if somewhat dirtier method of figuring break-even. It is described in the below worksheet. Although this approach may not be up to accounting school standards, it is highly useful for entrepreneurs, and more importantly, it can be done quickly, easily, and frequently as conditions change.

Once you get comfortable with working break-even figures in a simple fashion, you can get more complicated. You may want to figure break-even points for individual products and services. Or you may apply break-even analysis to help you decide whether an advertising campaign is likely to pay any dividends. Perform break-even analyses regularly and often, especially as circumstances change. Hiring more people, changing your product mix, or becoming more efficient all change your break-even point.

Break Even Worksheet

To determine your break-even point, start by collecting these two pieces of information:

1. Fixed costs. These are inflexible expenses you’ll have to make independently of sales volume. Add up your rent, insurance, administrative expenses, interest, office supply costs, maintenance fees, and so on to get this number. Put your fixed costs here: ______________________.

2. Average gross profit margin. This will be the average estimated gross profit margin, expressed as a percentage, that you generate from sales of your products and services. Put your average gross profit margin here: ______________________.

Now divide the costs by profit margin, and you have your break-even point. Here’s the formula:

Fixed costs / Profit Margin = Break-even point

If, for instance, your fixed costs were $10,000 a month and your average gross profit margin was 60 percent, the formula would look like this:

$10,000 / .6 = $16,667

So in this case, your break-even point is $16,667. When sales are running at $16,667 a month, your gross profits are covering expenses. Fill your own numbers into the following template to figure your break-even point:

$________________/________________= $________________

Current Ratio

The current ratio is an important measure of your company’s short-term liquidity. It’s probably the first ratio anyone looking at your business will compute because it shows the likelihood that you’ll be able to make it through the next twelve months.

Figuring your current ratio is simple. You divide current assets by current liabilities. Current assets consist of cash, receivables, inventory, and other assets likely to be sold for cash in a year. Current liabilities consist of bills that will have to be paid before 12 months pass, including short-term notes, trade accounts payable, and the portion of long-term debt due in a year or less. Here’s the formula:

Current assets / Current ratio = Current liabilities

For example, say you have $50,000 in current assets and $20,000 in current liabilities. Your current ratio would be:

$50,000 / 2.5 = $20,000

The current ratio is expressed as a ratio: 2.5 to 1, or 2.5:1. That’s an acceptable current ratio for many businesses. Anything less than 2:1 is likely to raise questions.

Quick Ratio

This ratio has the best name—it’s also called the acid-test ratio. The quick ratio is a more conservative version of the current ratio. It works the same way but leaves out inventory and any other current assets that may be a little harder to turn into cash. You’ll normally get a lower number with this one than with the current ratio—1:1 is acceptable in many industries.

Sales/Receivables Ratio

This ratio shows how long it takes you to get the money owed you. It’s also called the average collection period and receivables cycle, among other names. Like most of these ratios, there are various ways of calculating your sales/receivables cycle, but the simplest is to divide your average accounts receivable by your annual sales figure and multiply it by 360, which is considered to be the number of days in the year for many business purposes. Like this:

Receivables x 360 = Sales

If your one-person consulting business had an average of $10,000 in outstanding receivables and was doing about $120,000 a year in sales, here’s how you’d calculate your receivables cycle:

$10,000 x 12 = $120,000 1/12×360=30

If you divide one by twelve on a calculator, you’ll get .08333, which gives you the same answer, accounting for rounding. Either way, your average collection period is thirty days. This will tell you how long, on average, you’ll have to wait to get the check after sending out your invoice. Receivables will vary by customer, of course. You should also check the receivables cycle number against the terms under which you sell. If you sell on thirty-day terms and your average collection period is forty days, there may be a problem that you need to attend to, such as customer dissatisfaction, poor industry conditions, or simply lax collection efforts on your part.

Inventory Turnover

Retailers and manufacturers need to hold inventory, but they don’t want to hold any more than they have to because interest, taxes, obsolescence, and other costs eat up profits relentlessly. To find out how good they are at turning inventory into sales, they look at inventory turnovers.

The inventory-turnover ratio takes the cost of goods sold (better known by the acronym COGS) and divides it by inventory. The COGS figure is a total for a set period, usually a year. The inventory is also an average for the year; it represents what that inventory costs you to obtain, whether by building it or by buying it.

Average COGS / Average inventory = Inventory turnover

An example:

$500,000 / 4 = $125,000

In this example, the company turns over inventory four times a year. You can divide that number into 360 to find out how many days it takes you to turn over inventory. In this case, it would be every ninety days.

It’s hard to say what is considered to be a good inventory-turnover figure. A low figure suggests you may have too much money sitting around in the form of inventory. You may have slow-moving inventory that should be marked down and sold. A high number for inventory turnover is generally better.

Debt-to-Equity Ratio

This ratio is one that investors will scrutinize carefully. It shows how heavily in debt you are compared with your total assets. It’s figured by dividing total debt, both long- and short-term liabilities, by total assets.

Total debt / Debt-to-equity ratio = Total assets

Here’s a sample calculation:

$50,000 / 1:2 = $100,000

You want this number to be low to impress investors, especially lenders. A debt-to-equity ratio of 1:2 would be comforting for most lenders. One way to raise your debt-to-equity ratio is by investing more of your own cash in the venture.

Profit on Sales

Profit on sales, abbreviated as POS, is your ground-level profitability indicator. Take your net profit before taxes figure and divide it by sales.

Profit / Sales = Profit on Sales

For example, if your restaurant earned $100,000 last year on sales of

$750,000, this is how your POS calculation would look:

$100,000 / $750,000 = 0.133

Is 0.133 good? That depends. Like most of these ratios, a good number in one industry may be lousy in another. You need to compare POS figures for other restaurants to see how you did.

Return on Equity

Return on equity, often abbreviated as ROE, shows you how much you’re getting out of the company as its owner. You figure it by dividing net profit from your income statement by the owner’s equity figure—the net worth figure if you’re the only owner—from your balance sheet.

Net profit / Net worth = Return on equity

Return on Investment

Your investors are interested in the return on investment, or ROI, that your company generates. This number, figured by dividing net profit by total assets, shows how much profit the company is returning based on the total investment in it.

Net profit / Total assets = Return on investment For example, it might look like this:

$2,589 / $47,017 = 5.5%

Accounting Through the Ages

If you don’t understand accounting as well as you should, you can’t blame it on recent innovations. Double-entry accounting dates at least from 1340, and the first book on accounting, by a monk named Luca Pacioli, was published in 1494.

Surprisingly, a medieval accountant would feel quite comfortable with much of what goes on today in an accounting department. But accountants haven’t been sitting back and relaxing during the intervening centuries. They’ve thought up all kinds of ways to measure the health and wealth of businesses (and businesspeople).

There are more ratios, analyses, and calculations than you can shake a green eyeshade at. And wary investors are prone to using a wide variety of those tests to make sure they’re not investing in something that went out of style around the time Columbus set sail. So, although accounting may not be your favorite subject, it’s a good idea to learn what you can. Otherwise, you’re likely to be seen as not much more advanced than a fifteenth-century monk.

Buzzword: Liquidity

Liquidity measures your company’s ability to convert its noncash assets, such as inventory and accounts receivable, into cash. Essentially, it measures your ability to pay your bills.

Buzzword: Leverage

Leverage refers to the use of borrowed funds to increase your purchasing power. Used wisely, leverage can boost your profitability. Overused, however, borrowing costs can eradicate operating earnings and produce devastating net losses.

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