3 Critical Financial Ratios Small Business Owners Should Track
There are four ways to increase revenues and two to increase profits. You can increase revenues by increasing the number of transactions per customer, increasing the average sale, increasing the number of customers and raising prices. You can increase profits by lowering costs and/or increasing prices. Remember that your revenue is the total of all money you bring in and your profits are what is left after all expenses and taxes.
Most small business owners have an accountant or at the very least they use accounting software which can provide financial statements, balance sheets, etc. This is all good! You do not need to be an accountant to manage your business, you do need to calculate and track certain critical criteria. Waiting until the end of your fiscal year to see where you are at might be your downfall or you might have changed something you should not have because it was more successful than you thought.
The numbers you should track very closely are found on the following reports: Balance Sheet, Cash Flow Statement and your Income Statement. Your accountant creates these for you. Hire a good accountant, and make certain you understand what you are looking at and what your numbers mean. Learn to read these reports and keep track of critical numbers so you do not suddenly find yourself on the verge of bankruptcy. Take bold and immediate action if and when needed to continue moving towards your revenue and profit goals.
3 Critical Financial Ratios to Track:
- Gross margin (also called Gross Profit) = Income minus direct costs.
- Net income (also called Net Profit) = Revenues minus all expenses and taxes.
- Overhead to sales & Wages to sales ratios = Total overhead costs as a percentage of your income and total wages as a percentage of sales.
Let’s now take a look at each of these numbers to understand their importance and how they can affect your business short-term and long-term. Your net profit is directly affected by your sales, sales price and variable and fixed costs. Measure your financial performance regularly to obtain a clear image of your financial situation before you make any drastic decisions.
Gross profit or gross margin represents your profits left over after you deduct income minus direct costs. Gross profit is what you have left to pay indirect overhead costs. The direct costs are the costs associated to your products and services sold. Direct costs include: cost of purchase or manufacturing plus freight, customs, duties, losses, interest paid on product financed, local delivery (if you do not invoice for it separately), commissions and bonuses and direct advertising costs (if you allocate an advertising budget directly to this article).
Your net income or net profit is your bottom line. This is how much you have left after all expenses and taxes are deducted from your total revenue. Many forget to account for taxes paid. We have to pay the taxman, so this should be counted as an expense.
If the overhead to sales or the Wages to Sales ratios go up, figure out why. Many reasons can affect these ratios. Some are temporary and acceptable. Others may indicate a bad trend. For example, if your wages to sales ratio goes up because you have just hired a new salesperson, this is acceptable and temporary. If, however after a few months, this ratio stays high, there is reason for further analysis. Did this salesperson sell anything during this time? If so, do his sales cover his salary? If the answer is yes, it is an indication that sales from other sources are down. Tracking these two ratios on a monthly basis will help you keep costs at a reasonable level and take corrective action before they get out of control.
“You cannot improve what you do not measure.“
Small business owners are bombarded by interruptions. It is imperative to stay on top of key financial data on a regular basis. Don’t just rely on instinct or what you staff tells you. Track these numbers and more so you have a clear unbiased picture of where your business stands. Take immediate corrective action when needed to get back on track towards your goals.
You cannot improve what you do not measure. Manage your financials or they will manage you!