4 Financial Ratios to Better Understand Your Business
Some business owners confine their working knowledge of finances to what’s in the bank today vs. what needs to be paid today. Others will give a quick glance at monthly financial statements their bookkeepers have given them. But the most savvy business owners take those financial statements and examine some simple financial ratios in order to keep tabs on and improve their small businesses. These ratios should be compared to industry standards. (Don’t worry, there won’t be a test at the end!)
Also known as the acid test, the quick ratio is a way to understand how much money you have to deal with your current liabilities. It’s calculated by taking your current assets (excluding inventory, which is not quickly convertible to cash) and dividing it by your current liabilities.
A ratio of 1.0 is acceptable, but it means that you have only $1 of cash on hand to deal with each $1 of liabilities. Anything north of 1.0 means that you have at least a bit of cushion in case of a cash crunch.
Gross Profit Margin
This is often considered a “tell-all” metric and is something that should be monitored month-to-month and year-to-year as you want it to stay consistent. You calculate GPM by taking your gross profit (total revenues minus costs of goods sold – COGS) by your gross revenues.
What the margin is will depend on what kind of business you have. If you are selling a premium product, you typically see a higher margin, whereas if you are competing on cost, a low margin is more likely. As we said, it’s a number that should stay consistent so if your margin goes down it could indicate:
- Your costs have increased but you have not increased pricing to match
- You have a problem with shrinkage/unauthorized free giveaways
Net Profit Margin
This is a more granular version of the Gross Profit calculation. In the numerator, you will take total revenue and subtract COGS, but this time also take out operating expenses to arrive at net profit. Divide that by total revenue and you get your net profit margin.
If you’re unhappy with the number, there are a few remedies:
- Raise prices
- Decrease COGS
- Review your operating costs. Can you improve business productivity?
- Analyze your sales mix – is it diversified enough?
Average Customer Sale
If the previous three ratios examined your business at a macro level, this ratio examines it on a micro level by looking at each transaction with a customer. It is calculated by taking the total amount of sales divided by your number of customers. This number will allow you to identify what each customer is spending with you, on average. If this number is much lower than you expect, then there might be missed opportunities for add-on sales or associated products/services at the point of sale. If it’s much higher than you expect, it’s a great opportunity for you to see what is going right and lean into it!
There are a select group of people who live for numbers, but we know that most business owners don’t. If you need some help with these ratios, give us a call so we can help you better understand your business!