Most business owners know how important it is to keep an eye on their company's finances if they want to run a business that is financially sound. Fewer business owners know how important it is to use financial ratios to better understand their company's financial statements and, ultimately, to figure out how healthy their business is.
What are financial ratios?
Ratio analysis is a method of getting insight into a business’s liquidity, profitability and efficiency by delving into its financial statements such as the balance sheets and income statements. These ratios take raw data and turn them into information you can use to run your company more efficiently. For example, they can show you how profitable your business is or help you spot areas that could be risky. Financial ratios give you a snapshot into your business. The best way to get your financial ratios is to identify trends. Rather than looking at them once, continue to refer back and compare the information so you can get a clear picture over time.
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What is a net profit margin?
To figure out a company's net profit margin, take its total revenue and subtract all of its costs. This helps you understand how much of the money made from sales is profit. A high net profit margin shows that a business has a good handle on its costs. The formula to work out your net profit margin is net profit/sales X 100.
What is a gross profit margin?
While the net profit margin shows how much is left over after paying expenses, the gross profit margin shows how much money is left over after producing the product. The formula to work out your gross profit margin is net sales minus the cost of goods or services sold/net sales times 100.
What is an operating profit margin?
The operating margin is a way to figure out how much money a business makes after it pays its operating costs, like wages and raw materials, but before it pays interest or taxes. It is especially helpful for business owners because it figures out how much money the company makes from its main activities and leaves out any money that doesn't come from those activities. The formula for working out operating profit margin is gross profit - operating expenses/revenue x 100.
What is the working capital ratio or current ratio?
The current ratio, which is another name for the working capital ratio, is a good way to see if a business can meet its short-term obligations. Investopedia says that a working capital ratio of 1 or more means that a business's assets are worth more than its debts. The formula for working out working capital or current ratio is current assets minus current liabilities.
What is inventory turnover?
This ratio is helpful for businesses that need to keep track of their stock to figure out how well they sell their stock. It tells you how many times your average stock sells in a given amount of time. This empowers companies to keep the correct levels of inventory and avoid having goods sitting on the shelves or low inventory levels, which leads to missed sales. The formula for working out inventory turnover is the cost of goods sold divided by average inventory.
The bottom line
These five ratios will really help you understand how healthy your business’s finances are. Once you have the ratios in mind you will have a strong snapshot of your business overall, putting you in a much stronger position to make short and long term decisions to grow your business.