Avoid Stormy Seas by Staying on Top of Your Small Business Finances
Small business owners are extremely busy and they often have to wear many hats. Most of them don’t have the luxury of an internal marketing, customer service or HR department. Many owners have to fulfill these roles themselves and therefore find it very difficult to stay on top of their business finances. But getting on top of the financial measures of your business performance is an important part of running a business, especially if it’s in a growth phase.
There are a few key numbers that all small business owners must know by heart. These numbers will provide valuable insight and act as early warning indicators if something is about to go wrong. Without these indicators you may never know if your business is heading for disaster or not.
These numbers are most useful when converted to ratios. There are many types of ratios you can use to measure the efficiency of your business operations. Financial ratio analysis is nothing more than comparing specific pieces of information taken from your company’s balance sheet and income statement. These are some of the most commonly used ratios:
Gross Profit Margin Ratio
Gross Profits / Sales = Profit Margin
Gross profit margin will tell you how much money is made after direct costs of sales have been taken into account. If your gross profit margin is declining over time, it may mean that your inventory management needs to be improved or that your selling price is not rising as fast as your cost of goods. It is important to keep your costs under constant review. Keep checking that your costs are covered in the selling price.
Accounts Receivable Turnover Ratio
The Accounts Receivable Turnover Ratio measures the number of time accounts receivable turned over during a time period. A higher ratio indicates a shorter time between making a sale and collecting the cash.
Accounts Receivable Turnover Ratio = Net Sales / Net Accounts Receivable
Accounts Receivable Days on Hand
Once you have calculated Accounts Receivable Turnover Ratio you can convert it to the actual number of days accounts receivable are outstanding.
365 days / Accounts Receivable Turnover Ratio
Are your profits enough to cover your short term liabilities? You need the current ratio to answer that question. It helps measure the solvency of your business.
Current ratio = Current assets / Current Liabilities
As a rule, your current ratio should be 2 or more namely, your assets should be double your liabilities. A value less than one is a warning sign of potential cash flow problems. This is a helpful way for you to evaluate how your company uses its cash.
The quick ratio is also called the “acid test” ratio. The quick ratio looks only at a company’s most liquid assets and compares them to current liabilities. The quick ratio tests whether a business can meet its obligations even in adverse conditions.
Quick Ratio = (Total Current Assets – Total Inventory) / Total Current Liabilities
A quick ratio between 0.5 and 1 is considered acceptable if the collection of receivables is not expected to slow down.
Financial ratio analysis will help you to identify trends affecting your business. They are specifically helpful when compared with industry benchmarks. Dun and Bradstreet’s publication, “Key Business Ratios,” is available in most local libraries and includes financial ratios for hundreds of industries.