It is said that you could only manage what you measure…the only way to manage your business finances is through some key ratios…
There are some key ratios every business should know to understand the viability and health of your business. Managing your business finances and revenues can be a full-time job, and you might even have a full-time accountant on staff to handle the books. Many small business owners, however, prefer to handle this aspect of their businesses themselves or an outsourced accounting expert, foregoing an in-house accountant, to maintain control over their own books.
The access to information is therefore not the real issue seeing that it is produced either by yourself or by an accountant. It is the timing in which it is produced and the use of the data that often leaves businesses falling short when it comes to strategic decision making.
Here are some standard accounting formulas you should know. These formulas are generally regarded as universal to any business and will provide you with the figures you need to understand the viability and health of your business. Ratio analysis can get way more complicated and in-depth, but getting a grip on these as a starting point will already move you closer to achieving your goals.
“Ratios” Every Business Should Know
- The Accounting Equation
Equation: (Assets = Liability + Owner’s Equity)
What It Means:
- Assets are all the resources your business owns, including property, cash, inventory and equipment that will provide you with a future benefit.
- Liabilities are obligations that you must pay, including things like lease payments, merchant account fees and debt service.
- Owner’s Equity is the portion of the business that actually belongs to the owner.
- Net Income
Equation: (Revenues – Expenses = Net Income)
What It Means:
- Revenues are the sales or other positive cash inflow that comes into your business.
- Expenses are the costs that are associated with earning revenues.
- By subtracting your revenue from your expenses, you can calculate your net income. This is the money that you have earned at the end of the day. It’s possible that this number will be negative when your business is in its infancy stage, so the goal is for your business’ net income to become positive, meaning your business is profitable.
- Break-Even Point
Equation: (Break-Even Volume = Fixed Costs / Selling Price – Variable Cost Per Unit)
What It Means:
- Fixed Costs are recurring, predictable costs that you must pay to conduct business. These costs include insurance premiums, rent, employee salaries, etc.
- Selling Price is the retail price you sell your products or services for.
- Variable Cost Per Unit is the amount it costs you to make and sell your product.
- If you divide your fixed costs by the selling price of your product, minus the amount it costs to make and sell your product, you’ll have a break-even point, which tells you how much volumes you need to sell to cover all your costs.
- Cash Ratio
Equation: (Cash Ratio = Cash and cash equivalents/ Current Liabilities)
What It Means:
- This gives you an idea of how much cash you currently have on hand.
- Cash is simply the amount of cash you have at your disposal. This can include actual cash and cash equivalents (i.e. highly liquid investment securities).
- Current Liabilities are the current debts the business has incurred.
- This ratio demonstrates how well your business can pay off its current liabilities. In this case, the higher the number, the healthier your business.
- Profit Margin
Equation: (Profit Margin = Net Income / Sales)
What It Means:
- Net Income is the total amount of money your business has made after expenses have been removed.
- Sales are the total amount of sales you’ve generated.
- When you divide your net income by your sales, you’ll get your business’s profit margin. A high profit margin indicates a very healthy business. A low profit margin can reveal how unsuccessful a business might be, but it can also mean that your business doesn’t handle its expenses well. Remember that your net income is made up of your total revenue minus your expenses. If you have high sales revenue, but still have a low profit margin, it might be time to look at the figures making up your net income.
- Debt-to-Equity Ratio
Equation: (Debt-to-Equity Ratio = Total Liabilities / Total Equity)
What It Means:
- Total Liabilities include all the costs you must pay to outside parties, such as loan or interest payments.
- Total Equity is how much of the business actually belongs to the owner or other employees. In other words, it’s the amount of money the owner has invested in his or her own business.
- A high debt-to-equity ratio illustrates that a high proportion of your business’s financing comes from outside sources, such as banks. If you’re attempting to secure more financing or looking for investors, a high debt-to-equity ratio might make it more difficult to land funding.
- Cost of Goods Sold
Equation: (Cost of Goods Sold = Cost of Materials/Inventory – Cost of Outputs)
What It Means:
- Cost of Materials/Inventory is the amount of money your business should spend to secure the necessary products or materials to manufacture your product.
- Cost of Outputs is the total cost of the goods sold.
- By subtracting the cost of outputs from the cost of materials, you’ll know your cost of goods sold. This tells you if the costs you’re paying to make your product are in line with the revenue you earn when you sell it.
There are many more accounting formulas that you can use, but these seven are some of the more common. It’s best to have a good grasp of these formulas even if you’re not planning to manage your own accounting. The more knowledge you have regarding your finances, the better you can manage your business.
