You can’t just rely on your gut instinct when running a small business. You need to gauge the performance of the various business activities to gain insight into the company’s financial health as well as the effectiveness of its current strategies, identify areas for growth and spot problems, and make proactive decisions. This is where the role of financial metrics comes into play.
What are financial metrics?
Financial metrics take into account every aspect of financial performance that can be measured including sales turnover, profits, expenses, assets, liabilities and capital. In order to remain profitable and viable in the long run, small business owners should be clear about the basic concepts of financial accounting.
Businesses from diverse sectors use these financial metrics to monitor their operations, improve outcomes, enhance operational efficiency, support planning and strategy development, and prevent financial waste.
Which are the fundamental financial metrics every business should track?
As per the Corporate Finance Institute (CFI), below are the 10 key financial metrics you should monitor to ensure your small business is on track to achieving its goals.
1. Sales revenue
As revenue is the lifeline of any business, tracking it is crucial for any firm. Included in many performance indicators for businesses, this metric can determine whether your business is on an upward growth trajectory, stagnant or on the decline.
Sales revenue = No. of units sold x Average price
2. Gross profit margin (GPM)
Gross profit margin evaluates how effectively manufacturing costs are managed in proportion to sales. The higher the margin, the better the business’s performance. While calculating GPM, for accurate data interpretation, a comparison to industry standards is recommended.
Gross profit margin = (Gross profit / sales) x 100
3. Net profit margin
Another metric for tracking profitability is net profit margin, which shows how much net profit is generated for every dollar of revenue. If the margin is low, either selling prices need to be raised or costs need to be reduced.
Net profit margin = (Net profit / Sales) x 100
4. Net cash flow
The difference between cash inflows and withdrawals is measured as net cash flow. Every business has different cash flow requirements depending on its type or sector.
Net cash flow = Revenue + Increase in liquid assets – Expenditures + Increase in liabilities
5. Working capital
Working capital is a testament to a company’s capacity to fulfill its immediate obligations. Basically, it’s the capacity to use short-term assets to fund payments to meet obligations that are due soon.
Working capital = Current assets – Current liabilities
6. Debt-to-equity ratio
This ratio gauges how much debt and how much equity make up a business’s capital structure. When the ratio is more than one, it indicates that the majority of the capital is derived from debt. The ratio also determines the inherent risks such as the inability to pay off all debt in the event of a business slump thus providing insights into the business’ solvency.
Debt-to-equity ratio = Total liabilities / Shareholders’ equity
7. Current ratio
The ability of a business to pay short-term obligations as they come due is measured by the current ratio. Desirable ratios depend on industry standards, however, a ratio of more than one serves as a benchmark for the entire economy.
Current ratio = Current assets / Current liabilities
8. Inventory turnover
It measures how well an investment in inventory produces sales over a given time frame. It serves as an indicator of how quickly a company can sell stocks. The higher the ratio, the greater the efficiency level.
Inventory turnover = Cost of goods sold / Average inventory
9. Days sales outstanding (DSO)
Day sales outstanding estimates the typical number of days it takes a business to collect money from credit sales and shows the efficiency of credit sales collection. The company is considered to be more efficient at collecting money when the number of days is less. It may be calculated every month, every three months, or every year.
Days sales outstanding = (Average account receivables / Total net credit sales) x 365
10. Days payables outstanding (DPO)
The average number of days it takes a business to pay its suppliers is determined by days payables outstanding. The higher the number of days, the longer it takes for a company to pay its suppliers, and in some instances, the higher the business’s negotiating power over its suppliers. A higher ratio, however, can be taken as a lack of ability to pay.
Days payables outstanding = (Average account payables / Cost of goods sold) x 365
While the above-mentioned financial metrics help you monitor and analyze key aspects of your small business, to accurately evaluate its financial health and long-term sustainability, make sure to consider several metrics in tandem.
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This material has been prepared for informational purposes only. Escalon and its affiliates are not providing tax, legal or accounting advice in this article. If you would like to engage with Escalon, please contact us here.