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Power of Profitability: The Financial Ratios You Need to Check

business.com editorial staff
business.com editorial staff

How do you measure business success?

There are a number of commonly used metrics you can turn to, each of which gives you a different kind of business intelligence.

Gross Profit

As Micawber says in David Copperfield:

Annual income twenty pounds, annual expenditure nineteen pounds nineteen and six, result happiness. Annual income twenty pounds, annual expenditure twenty pounds nought and six, result misery.

Amazon used to be the one exception to the notion that profitability need not be the primary measure of success. This was a concept that led to the dot-com bubble collapse in 2001, in which non-profitable companies became non-existent companies. Amazon was one of the few that recovered and today shows a greater willingness to commit to this basic metric, even as continuing expansion strains its resources. Because there is only one Amazon, Micawber’s caution remains the prime directive.

But it is not the only one.

Related Article: Fixed and Variable Expenses: How Cost Structure Determines Your Profitability

Gross Margin 

Gross margin is gross profit divided by total revenues. Unlike gross profit, which tells you how much you made (what’s left over after all your expenses), the gross margin measures efficiency, as opposed to how much money you can put in your pocket. The higher the percentage, the more efficient you are.

According to the Small Business Administration (SBA):

It may sound obvious, but understanding gross margin is often overlooked by start-ups and new business owners. This can have a direct impact on your ability to effectively manage a growing business, price your products and, most importantly, make a profit.

Consider this simple example. Your revenues are $1 million and gross profit is $250,000. Your gross margin is 25 percent.

The following year, you make $2 million. That’s good right? You doubled sales. But consider that your gross profit is still $250,000. Your gross margin dropped to 12.5 percent. In other words, you worked twice as hard to make just as much.

If your gross margin is dropping, it’s time to look at how you can reduce overhead. Similarly, if your gross revenues remain stagnant over time, and your overhead costs fixed, it might be time to look at your pricing strategy. Can you raise prices and still maintain the same level of sales or, conversely, can you lower prices in expectation that it will increase sales even as overhead remains the same? 

Revenue per Employee

Appropriate staffing levels are always a concern. If there are not enough people to get the jobs done right, your product quality and customer service can suffer, leading to declining sales. But too many people leads to increased expenses, which leads to decreased profitability.

One way to measure this is to divide your revenues by the number of employees. There’s no hard rule on how many employees you should have in proportion to your profits, but there are industry averages.

If your competitors seem to be doing better with fewer employees, it could be a flag that it’s time to take a look at who is doing what and how effectively are they doing it. 

Inventory Turnover

It costs money to maintain inventory. Inventory turnover is the number of times inventory is depleted over time. It is calculated by dividing the COGS by the average inventory during a month, year, week or other period.

Mike Periu of Proximo International points out:

If the ratio is too high, it means that you are selling out of your inventory too quickly and may be missing out on additional sales if you maintained higher inventory levels. If it’s too low, then perhaps you are overestimating your demand projections, aren’t pricing your products correctly or are experiencing some other problem. 

Related Article: Which is Better: Cash or Accrual Based Business Accounting?

Current Ratio

The Current ratio is the current assets (cash, inventory, accounts receivable and anything else the company owns that can be converted into cash in the upcoming year) divided by current liabilities (debt and accounts payable, what you need to pay out in the upcoming year).

This is a measurement of your ability to pay your bills on time. The higher the ratio, the higher your ability to pay your obligations.

A ratio of 1 indicates you’ve got just enough to pay your bills (and would need to liquidate to do so): under one and you’re in the red. However, as Investopedia notes, while this indicates you’re not in the best financial condition, it needn’t mean you are about to go bankrupt.

“For example, if a company has a reasonable amount of short-term debt but is expecting substantial returns from a project or other investment not too long after its debts are due, it will likely be able to stave off its debt.” 

That said, a current ratio of 1 or less isn’t good news. Nor is a current ratio that is too high. While you might think a high current ratio indicates superior financial stability, anything higher than 3 is generally considered an indication that you aren’t managing your working capital and assets efficiently. 

Why You Need an Accountant 

Every business owner should be aware of these ratios. However, a given ratio in and of itself doesn’t necessarily predict the success or failure of your business.

To truly get the big picture, you need someone who really understands not only the ratios themselves (as well as others), but also what they all mean in relation to one another. In other words, you need an accountant.




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