No matter what the time of year, it is a good idea to begin to establish healthy financial habits that you can carry with you throughout the year. When looking back on the previous year, a business owner might say that they had a good year or a bad year based upon the gross sales or net income or loss the business generated. While these simple metrics can give provide a glimpse into the relative health of a business, they don't always provide enough information to not only evaluate how well a business is doing but also to diagnose potential problems before they have a significant negative impact on the business.
A much more useful tool to help a business owner measure the effectiveness of their business decisions and diagnose and treat problems before they become too serious is the use of financial ratios. Financial ratios are calculated using figures drawn from a business' balance sheet and income statement. There are a number of software packages that can prepare these statements, such as Quickbooks. These ratios can help to measure the earning potential of the company, a company's ability to meet both short and long term payments, and how well the company is managing its assets. These things can be very important for the business owner to know, but will also be of interest to potential lenders if the business owner applies for a loan.
Generally, there are two ways that these ratios can be used. One is to determine how well a company is performing over a period of time. The same ratios can be calculated for a business on a monthly or quarterly basis to see whether business decisions are having the desired effect. The second is to benchmark a company's performance to another company or an industry as a whole. An excellent resource for free industry ratio data is www.investor.reuters.com.
One particularly important ratio is the cashflow cycle. It measures the number of days it takes to convert inventory and receivables into cash. This is a ratio that measures management performance and is calculated by adding receivables and inventory and then dividing that number by the cost of goods sold.
Another common ratio which is used to evaluate the profitability of a business is the gross margin percentage. It is calculated by subtracting the cost of goods sold from total sales and dividing that number by the total sales. It is important to note that these ratios can vary widely among different industries. For example, the industry average gross margin for apparel is 53%, whereas for construction, it is 19% so comparing apples to apples is important. In next month's column, I will discuss some of the other more commonly used ratios and how to put them to work for your business.
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