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by Dale Gillmore
Just as you take the time to meet with your physician annually, it’s important to step back and assess the health of your business just as often.
Knowing your company’s vital signs -- the numbers and ratios bankers and investors would use to assess its health -- is the first step in making sure you spend your time and business resources wisely. More importantly, failing to recognize any shortcomings you’re facing can have disastrous consequences.
In our Explore Package, we get to know you, your business, and your ultimate goals. Utilizing our best thinking and innovative technologies, we provide insight into the health of your business and reveal opportunities for improvement and growth, so you can move forward with certainty. The package includes:
For the purposes of this blog, we’ll cover just a portion of that package.
Here are seven key financial metrics that can help you understand your business, how you’re faring against competitors, and what areas need attention:
• Pre-tax net profit margin
• Current ratio
• Quick ratio
• Accounts payable days
• Accounts receivable days
• Inventory days
• Debt to equity ratio
Pre-tax net profit margin
Probably the most important metric, this tells how much profit you get to keep from each dollar in sales. For private companies, it is usually expressed as net profit before taxes in a given financial period divided by sales.
This number can show you how effective you’re being with expenses and if you should decrease certain expenses so that they don’t eat up as much of the revenues. The average net profit margin for private companies is around 7%, but it can vary dramatically by company and by industry.
Current ratio and quick ratio
These two metrics give you an idea of your liquidity, or how well you can meet your near-term obligations, and they are most helpful analyzed together. If the business does not have decent liquidity, then one unexpected expense could severely impact it.
Current ratio basically shows whether the assets that you can convert into cash quickly (within a year) will cover what you must pay off soon (in less than a year), and it is expressed as current assets divided by current liabilities. A ratio of less than one means you could run short of cash within the next year unless you generate additional cash.
The quick ratio shows a shorter-term view; it divides cash plus accounts receivable by current liabilities. The average private company’s quick ratio is 2.15.
Accounts payable days and accounts receivable days
These ratios help show how you’re managing the company’s cash position so that at any point in time, you have enough to cover commitments.
Accounts payable days can indicate whether you’re paying your suppliers too quickly and losing out on money you could be investing instead of distributing immediately.
What’s a good accounts payable turnover ratio? In general, higher numbers are better, but it can vary by industry pretty dramatically.
Accounts receivable days, meanwhile, can alert you when you’re not receiving payments from customers quickly enough. (It is expressed as accounts receivable divided by sales multiplied by 365 days.) Generally, lower numbers are better for accounts receivable, because it means you’re getting cash quickly. But this, too, will vary dramatically by industry.
The inventory days ratio (inventory divided by cost of goods sold, multiplied by 365 days) measures the number of days it takes to move inventory, but it is very specific to the industry. For example, restaurants’ products have a short shelf life relative to a clothing store’s merchandise. Still, lower numbers are generally better, because you want to turn over as much inventory as possible in a year.
Debt to equity ratio
Debt-equity ratio is one of the ways to measure your business's financial health. Dividing total liabilities by the owners' equity shows how much of the company's assets are tied up in debt. The higher the ratio, the more indebted the firm. Some debt/equity ratios plugin only long-term debt rather than all debt.
It is possible to grow your company by borrowing money to fuel expansion, but too much debt poses a risk. If you're expanding, but your debt ratio is too high, that's a sign your growth is fueled primarily by debt rather than substance. That's a risky strategy because companies can't sustain debt-fueled growth indefinitely without significant growth in profits.
Because all of these metrics can vary by type of industry, it’s difficult to make sense of financial ratios unless you find quality benchmark data that gives insight into businesses of similar industry, revenue size, and geographical location.
While your CPA and other advisors might be able to provide you these raw numbers and ratios, understanding their context and obtaining a deeper financial analysis is critical to understanding what’s possible for your business and what you can do to improve it -- key elements that set the stage for future success.
Give us a call to get started.