Key Business Ratios to Guide the Financial Performance of Your SME
Performance assessment is a huge part of growing a business. Periodically, it is important to assess how far the business is growing or otherwise, particularly in relation to the benchmarks you set or as compared with previous reports. One way to easily assess comparative growth on a company’s financial performance is through ratio analysis. It is a quantitative tool used to assess one’s business in the areas of liquidity, efficiency, profitability, debt, and more.
Just as these ratios are useful for auditors, investors, and banks who want to assess companies’ actual performance for various reasons, they’re also a useful tool for small business owners who can make decisions and birth effective strategies. They can help you keep track of your business’s growth and provide you with insights that will prove useful for advancing your small business in the long run.
What are Business/ Financial Ratios?
Business ratios are also referred to as financial ratios. They are tools that help convert raw numbers into useful information, and they help you manage your business better and more conveniently. Business ratios help you analyse seemingly inconsequential numbers and help you read between the lines to get insight.
They are a type of key performance indicator (KPI). There are several other KPIs to tack, but financial ratios are mostly concerned with information found on your financial statements.
Here are some important business ratios to guide the financial performance of your SME:
Gross Margin Ratio
Gross Margin Ratio = Gross Profit (Sales – Cost of Goods Sold) ÷ Total Sales.
This ratio will prove even more important for businesses that sell products. It helps you keep stock of how much money you have to cover your operations after paying for the products you sell. You can either measure your gross margin ratio by product or in total for your business. The idea is that if your direct cost or cost of goods sold is low, you’ll end up having more income to cover other necessary expenses.
Net Profit Margin
Net Profit Margin = (Total Revenue – Total Expenses) ÷ Total Revenue.
Your net profit margin refers to the percentage of your remaining revenue after all operating expenses, interest, and taxes have been deducted. Net profit margin is an important ratio because it shows how effective your company is in managing costs and turning your revenue into profits. It measures how much profit you have left from your sales. Several problems can be the cause of a poor or declining net profit margin. It could be an indicator of poor customer service or a bad job with monitoring consumable office supplies. It could also mean that your company has an employee theft problem.
This ratio also measures your company’s liquidity in terms of your ability to pay short-term obligations as at when due. It helps you assess the available working capital the company has to meet its recurring obligations. Beyond profitability, one of the issues companies need to mitigate against is the unavailability of cash to keep the lights on. Working capital is the amount of money needed for your business to fund your short-term operations. Working capital is the difference between your current assets and liabilities.
The current ratio, which is sometimes called the working capital ratio, allows investors and analysts to better understand your company’s actual operational performance in servicing short-term debt and other forms of payables. Your current ratio shouldn’t be significantly higher or lower than others in your industry, as either of these could mean a red flag. If it’s significantly lower than those in your industry, it implies that your business has a high risk of default or distress and a high current ratio. It means your company may not be efficiently using its assets.
Return on Investment
Return on Investment (ROI) = Net Profit / Total Investment
While this may not be a major concern for SMEs, it is good practice to stay abreast of the value being created for investors in the company. The return on investment ratio exists simply to show the investment gain to the amount invested. It, therefore, creates room for a business owner to figure out exactly how efficiently the company has made use of its total investment or asset base to make revenue and yield returns.
Ratio analysis helps companies make key business decisions from a point of knowledge. Other key business ratios to pay attention to guide your SME’s financial performance efficiently include; debt ratio, inventory turnover ratio, and debtors turnover.