Every dollar you spend should deliver returns so you can grow your business, pay your employees and still make a profit. But how can you be sure that’s the case?
Your bank account alone tells only part of the story. You need objective ways to measure the performance of your business. Financial ratios give you that because each ratio gives you a different insight into your business.
Financial ratios are calculations based on the information in your financial statements. Here are a few ratios every business owner should track:
- Net profit margin and gross margin tell you how much profit you are making
- Working capital ratio is a good indicator of how easily you can pay off existing debt and if you have the cash flow needed to expand your business
- Receivable turnover is a measure of business activity and liquidity and how easily you can convert your assets to cash
- Inventory turnover tells you how fast your goods are selling, which is an indicator of market demand
So how do you use these ratios to fine-tune your business? Here are four tips:
1. Determine the relevant ratios
Every ratio gives you a different kind of insight into your business. How you use them depends on your particular goals and circumstances.
For example, if you’re looking to grow and need to raise capital, your net profit margin will be key. The more profit you can show, the better your chances are of raising the cash you need.
On the other hand, if you’ve launched a new product, you’ll want to track your inventory turnover to make sure you’re aligned with demand. You want to see that the inventory you keep isn’t old news, and that people want to buy the product. You always want to be adapting and innovating, and ratios can help you do that.
Some ratios are important to specific industries. For example, occupancy ratio is used in the hotel sector, capital adequacy ratio in banking and sales per square foot in retail. The customer lifetime value to customer acquisition cost (CAC) ratio is often used in the tech sector, especially by software as a service (SaaS) entrepreneurs. It’s important to know which ratios give information relevant to your sector.
2. Monitor the trend
Once you’ve determined which financial ratios to use, compare the results over time to pick out trends or changes in your business performance. If your net profit margin climbed regularly for three years and then took a dip, what changed? Were your revenues down in one quarter? Have your costs gone up? Do you need to take any actions?
3. Compare against industry
You also need to know how your business compares to others in your industry. With financial ratios, there is no magic number a business should strive for. Every company and every industry is different.
Knowing the industry average, however, gives you a general sense of where you want to be. Average ratios are also available for complete sectors and companies of comparable size. Use these as benchmarks to see how you stack up next to the competition and to set realistic improvement goals.
4. Incorporate financial ratios in your strategy
The insights that come from the ratios you use should shape the direction of your business plan. Status quo can kill the potential of a business, so you always want to be adapting and innovating. Financial ratios can help you do that.
For example, if you’re not turning over your receivables fast enough, you may have a cash flow problem. You can address that by changing your procedures or company culture to collect payments more proactively. Or if you see your inventory is turning over too slowly, maybe you need to look at your product mix and either add something new or get rid of something old.