When you own or manage a business, it can be very easy to get pulled into the day-to-day demands, working in your business more than you have the opportunity to work on your business. So, when you have some moments to take a step back and work on your business, what are some things that are helpful to be aware of to know how your business is performing? The beauty of accounting is that, if the numbers are properly accounted for (in other words, you are regularly on top of your bookkeeping), you can use the numbers to understand how your business is doing.
The numbers tell a story, and the following are some ways you can use your numbers to know the story of your business. The tools we will be discussing here are called financial ratios, and so doing this is called ratio analysis. Do not worry if it sounds a bit nerdy or technical, it can actually be pretty straightforward, so let’s dive in.
Ratio analysis is effectively what is sounds like, analyzing ratios. While there are many ratios that we can look at when it comes to the value or performance of a business, the 5 ratios we will be looking at here which you can start using today, are the following:
1. Gross Profit Margin
Your gross profit margin is the ratio of your profit from the sale of your products and/or services, compared to your overall revenue. It calculates how much profit your business makes after considering your cost of goods (or services) sold. A high gross profit margin indicates that a business is able to sell its products at a higher price than it costs to produce them, which is typically a good sign of a healthy business.
Calculating your gross profit margin can be done by dividing your gross profit by your revenue, and multiplying that number by 100 to get a percentage value.
Gross Profit Margin = (Revenue – Cost of Goods Sold) ÷ Revenue x 100
For example, if you have revenues of $500, and your direct costs to manufacture what you sold were $320, then you would have a gross margin of 36%. This would be calculated as follows:
Gross Profit Margin = (500 – 320) ÷ 500 x 100
If you are looking for a similar metric to get a better understanding of the profitability of specific products or services that you have, click here to read more on your Contribution Margin.
2. Net Profit Margin
Your net profit margin is the ratio of net income (or profit) compared to total revenue. This ratio shows how much profit your business makes after accounting for all expenses, including what is often referred to as general and administrative overhead (G&A). A high net profit margin means your business is generating a lot of revenue relative to all of your expenses.
Calculating your net profit margin can be done by dividing your net income by your revenue, and multiplying it by 100 to get a percentage value.
Net Profit Margin = Net Income ÷ Revenue x 100
If we use the example from above, if you have revenues of $500, your costs to manufacture what you sold were $320, and your general and administrative costs were $140, you would have a net profit margin of 8%. This would be calculated as follows:
Net Profit Margin = (500 – 320 – 140) ÷ 500 x 100 Another way of saying this would be that 8% of your sales revenue would be net profit.
3. Current Ratio
Your current ratio compares your current assets to your current liabilities. As a quick refresher, generally speaking, assets are what you own, and liabilities are what you owe. Current assets are assets you will likely use in the coming year (cash, accounts receivable, inventory, prepaid expenses, etc.), and current liabilities are what you owe that will need to be resolved in the coming year (accounts payable, current interest on long-term debt, etc.). Given that the current ratio deals with both current assets and liabilities, this ratio shows if your business has enough assets to cover its liabilities in the short term.
Calculating your current ratio can be done by dividing your current assets by your current liabilities, as follows:
Current Ratio = Current Assets ÷ Current Liabilities A current ratio greater than 1 indicates that there are more current assets than current liabilities, whereas a current ratio of less than 1 indicates a potential challenge in being able to resolve short-term liabilities in the coming year, as they exceed current assets at the time.
To use an example, if you have current assets of $150,000 (say a combination of cash and accounts receivable), and you have current liabilities of $75,000 (say a combination of accounts payable and interest payable on debt for the year), your current ratio would be 2, which would mean you have 2 times the current assets needed to meet your short-term debt obligations.
If you require financing for your business, the current ratio is often one of the financial ratios that lenders will look at for your financing application, and may monitor over the course of your financing term. In fact, it is not uncommon that lenders include lending covenants as part of your financing agreement, which often include current ratio covenants, such as the requirement to maintain a current ratio above 1.5, for example.
Your Debt-To-Equity ratio measures your business’s total debt compared to your total equity. A high Debt-To-Equity ratio is an indicator that your business may be highly leveraged, which means it may be heavily reliant on debt financing. As such, this ratio also tends to be a common one that you may see in lending covenants, similar to the current ratio discussed above.
Calculating your Debt-To-Equity ratio can be done by dividing your total debt by your total equity, as follows:
Debt-To-Equity = Total Debt ÷ Total Equity
Your total debt is typically calculated by adding your current liabilities (such as accounts payable) plus your long-term liabilities (such as mortgages or capital lease obligations). If you are negotiating financing with a lender, and this ratio is included in the draft lending covenants, you may want to consider the impact that some of the components of your total debt may have. For example, it is not uncommon for larger contracting companies to have pay-when-paid clauses in their subcontracts with vendors, and so their accounts payable balances are often directly tied to their accounts receivable balances. If your business finds itself having large outstanding receivable balances at the end of an exceptionally high revenue fiscal period, there may also be large corresponding accounts payable balances at the end of the fiscal period, which may significantly drive up your Debt-To-Equity ratio compared to prior periods, with the risk of this putting you offside on this lending covenant. If this might apply to your business, you may want to discuss with your lender the possibility of adjusting your accounts payable balances that are directly tied to accounts receivable balances under pay-when-paid clauses, as this would decrease the negative impact that high revenue periods may have on your Debt-To-Equity ratio.
It is important to recognize the place for debt in business, as there are many who are understandably averse to debt. If your business requires additional financing, and you are faced with the option between debt or equity financing, typically what you may find is that equity financing tends to be more expensive, as investors will tend to want to see a greater return on investment than market interest rates. On the other hand, although debt financing tends to be less expensive than equity financing, you may find that it may come with greater restrictions, such as maintaining specified lending covenants (as discussed above), or there may even be restrictions on dividends paid to shareholders.
5. Return On Equity (ROE)
Your return on equity (ROE) is the ratio of net income to your total equity. This ratio shows how much profit your business generates for each dollar of equity you have in your company. A high ROE indicates that your business is generating a lot of profit relative to your equity.
Calculating your ROE is done by dividing your net income by total equity as follows:
Return on Equity = Net Income ÷ Total Equity
For your company, your total equity is equal to your common and preferred shares. If you think of your total equity as being your initial investment in your company (such as perhaps your purchase of the shares in an acquisition), your ROE can be viewed as an indicator of your return on investment (ROI) for a given period. Monitoring this ratio can then help give you an idea of the best deployment of capital that you may have. It is not uncommon for well performing businesses to have an ROE that outperforms ROI in the equity markets. However, if you find that your ROE is quite low, or even negative on an ongoing basis, it may help in determining if perhaps your capital (and efforts) would be better deployed in another investment activity. Of course, this is a hard discussion to have, and there are many other variables to consider beyond simply looking at your ROE.
Now that you understand these ratios, you can track how these change each month, as you analyze your monthly financial information. This will help highlight any trends that you may want to look into further when it comes to your business performance, maximizing positive trends, and mitigating negative trends. You can also use these metrics to benchmark your business’s performance against others in your industry, by using industry data that may be available, such as through the Industry Canada Small and Medium Enterprise financial performance reporting tool.
There are many other metrics to consider, such as AR turnover, interest coverage ratio, revenue growth, and others, which will be covered in a different post. These particular metrics that we cover here really help keep a good pulse on the performance of your business, and help you to make more informed decisions about your business’s finances.
If you would like to receive periodic emails containing more helpful tips for your business, please subscribe here.