It’s obvious that not everyone is cut out for math. However, if you go into business, there are some important metrics that you should learn and understand well. Simple items that you should know include: your cost of goods, profit margin, sales per square foot, payroll percentage, advertising percentage, inventory turnover, return on equity, and liquidity ratios. These are very basic and fundamental, especially for product-based businesses. All formulas in this post work best for an annualized period.
Every industry is different. Some industries have a high volume of sales with low profit margins while, in other industries, the opposite may be true. As a business owner, you should seek to compare your business and strive to be the best in your industry. Obviously, a mini-mart will have a lower profit margin than an upscale restaurant.
First, you must know how much your goods cost and make sure you are making a healthy profit margin. You costs of goods are calculated by:
Cost of Goods = Beginning Inventory + Purchases – Ending Inventory
Relying on intuition alone here doesn’t cut it. Many small product businesses do this. Intuition can be misleading because a lot of money can be spent on materials that remains tied up in inventory at the end of the period. This may lead you to think you’re overspending when you’re actually very profitable.
Next, business owners need to know their gross profit margins. The profit margin on your products accounts for all operating expenses including labor, rent, utilities, materials, etc. It is calculated as follows:
Profit Margin = 1 – (Cost of Goods / Sales of Goods)
Keep in mind that a small percentage can make a world of difference for many businesses.
Next, how well are you utilizing the space in which you rent? Sales per Square Foot is a good metric to analyzing this. Are there competitors that are able to carry as much product and make as many sales with less space? Here is the calculation:
Sales per Square Foot = Total Sales / Square Feet
How much of your total sales is paid for labor? How do you compare to other businesses in your industry?
Payroll Percentage = Total Payroll / Total Revenues
Advertising is an expense in which you can easily overspend in comparison with how much business the advertising generates. General advertising through traditional media is generally expensive and it’s usually impossible to pinpoint how much you are getting in return. Direct advertising, such as direct mail and pay per click online, is easier to quantify and understand its effectiveness. Similar to the payroll calculation, advertising cost is viewed as a percentage of your total sales:
Advertising percentage = Total Advertising Costs / Total Sales
How fast is your inventory turning into sales? Inventory turnover is a key metric in determining how fast your inventory cycle is. The faster you turn your inventory, the less time your cash is tied up. The calculation is as follows:
Inventory Turnover = (Beginning Inventory + Purchases – Ending Inventory) / (Ending Inventory * Number of Periods)
Many business calculate this based on 4 periods per year. That is, each period is one quarter. In general, the higher the inventory turnover, the better your cash flow is. You can usually improve inventory turnover through redesigning business processes and software.
Return on Equity tells you what your return is on the net worth of your company. This is a function of your profits and the difference between your assets and what you owe on them.
Return on Equity = Net Income / (Total Assets – Total Liabilities)
For return on equity, you should aim for a percentage that is at least in the high teens, higher if you’re in a fast growing industry. Be careful with this metric, however. A high number could be an indication that you are too far in debt. On the other hand, I feel that this is one of the most important metrics of a business.
Liquidity ratios are important in determining how well you are managing your short term cash. I tend to lean towards the conservitive side here. There are two ratios I want to introduce. The first is the Current Ratio. This is simply:
Current Ratio = Current Assets / Current Liabilities
I typically prefer to maintain a 2 to 1 ratio here. Some businesses, such as Wal-Mart, have consistent enough cash flows in which they can operate on a lower ratio. This is because the income they have coming in is very steady and is turned into cash quickly. There is nothing tied up in accounts receivable for long periods of time.
There are many business that build up inventory and accounts receivable too fast and the ratio between accounts receivable to sales increases. As a side note, before investing in a company (or buying a stock), always look at how fast inventories and accounts receivable is increasing in relation to sales. If inventory and accounts receivable are rising faster than sales, it should be a red flag.
The amount that you have in accounts receivable is important in two ways: 1) the actual balance and 2) how fast you typically collect on these. High balances with long collection periods may lead to disaster because the business still has yet to collect the money from the sale and it must buy new inventory and operate in the mean time. It can also be misleading because accrual accounting allows a business to book the sales as income prior to collecting the money. The important concept here is that a company’s management can decieve investors buy showing rapidly increasing sales when they are recklessly financing their customers.
The Acid-test Ratio is similar to the Current Ratio but it strips out inventory. This ratio should, for most businesses, be greater than 1 to 1.
Acid-Test Ratio = (Cash + Accounts Receivable + Short-term Investments) / Current Liabilities
When you use these ratios, you should compare them to other businesses within your industry. Some industries are more capital intensive than others and some have steadier cash flows than others. The more capital intensive and the more erratic your cash flows are, the more conservative you should be when financing your company.