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6 financial ratios every entrepreneur should master

News  •  Jul 28, 2011 06:12 SGT

Business school teaches us a stack of financial ratios to measure performance. For service-based businesses, I suggest mastering these six. They include a healthy serve of profitability, with a dash of liquidity and efficiency. Use these ratios to measure your company's performance and the value of your business if you decide to sell.

1. Current ratio

The current ratio measures liquidity and gauges how capable a business is in paying current liabilities by using current assets only.

Current Ratio = Total Current Assets / Total Current Liabilities

A general rule of thumb for the current ratio is 2 to 1 (or 2:1). That means you own twice what you owe. For service based businesses where salary and rent are their largest outgoings, this is a good ratio. If it starts looking like 3:1, you may have an oversupply of cash or your carrying large accounts receivable. This is a good problem - cash is an opportunity wasted in a bank account.

A 1:1 ratio is a place you don't want to be. You are not liquid enough, and likely to encounter a cash squeeze while waiting for accounts receivable to convert to cash. If you sense your firm approaching a 1:1 position, take evasive action:

  • Convert non-current assets to current assets;
  • Increase current assets with new equity contributions;
  • Put profits back into the business;
  • Increase your current assets using short term loans or other borrowings.

2. Gross profit ratio

Before calculating gross profit margin, first derive the gross profit.

Gross profit = sales - cost of goods sold

For most service-based businesses (excluding F&B), cost of goods is very small, so gross profit reveals little. Gross profit margin is more telling, measuring a business's pricing and production efficiency. A company with a strong brand can command a high price. A company with talented project managers will achieve high efficiency.

Gross profit ratio = gross profit / net sales

Gross profit margins are largely dictated by how well managers negotiate and lead people. Examine individual projects using gross profit margin, and discover the company's most valuable staff. These are managers are valuable. They can price correctly and control costs. In businesses which are not project-based like a SaaS provider, margins tend to be smaller but are less susceptible to fluctuations. These businesses influence gross profit margins at a more global level, by modifying perceived value and price.

Investors tend to pay more for businesses with above-industry efficiency ratings, as they expect these businesses to make profits as long as overhead costs are controlled (overhead refers to rent, utilities, etc.). Businesses with healthy gross profit margins can sustain bigger hits, compared to businesses with thin margins, which are more vulnerable. Outsourcing has been one way service-based businesses have improved gross profit margins over the last decade.

3. Net profit margin

Net profit margin shows how much net profit is derived from every dollar of total sales. It indicates how well the business has managed its operating expenses. It also can indicate whether the business is generating enough sales volume to cover minimum fixed costs and still leave an acceptable profit.

Net profit margin ratio = net profit (before tax) / net sales

A business which achieves high gross profit margins, may score a poor net profit margin. Variable costs rise undetected because they are not tied to a project. In such situations business owners ask themselves “What's going on - we are working hard and not making any money?”

Service-based businesses scaling head count often encounter this problem. Variable costs like personal, printer cartridge, paper and pantry expense can rise sharply. What was a small cost can become a large figure when multiplied across many staff. Before scaling headcount, have in place systems and checks to set limits on variable costs. Place expensive consumables under lock and key and track photocopying and printing via IP. You may need to even hire a secretary to ensure guidelines are adhered to.

4. Accounts receivable turnover

This ratio shows the number of times accounts receivable are paid and reestablished during the accounting period. The higher the turnover, the faster the business is collecting its receivables, and the more cash on hand.

Accounts receivable turnover = total net sales / accounts receivable

A company healthy services business scores 3:1 or 4:1. A company which cannot demonstrate to an investor they can collect debts may be devalued, even though it has high net profit margins. Either not enough money is being spent on collection, or the clientele are poor payers. If you are planning to sell a business, tighten your collection process. Introduce better terms for early payers, collect more deposits, automate your invoicing system and prefer TT payments over cheque.

5. Profit per square foot

This is one you won't find in a text book. Rent is one of the largest fixed operating expenses a services business faces, so it's not unreasonable to calculate the return on rent to the business. After all office space is much like plant - it's where the work gets done.

Profit per square foot = net profit (before tax) / square feet of office space

For example, the cost of keeping one permanent employee in the company annually may be $3,000 per year. You want to make sure the person occupying this space is a producer, contributing to the bottom line. This is one reason why outsourcing finance functions to Futurebooks makes sense - you free up limited space to make room for sales / operation functions.

6. Profit per head

Calculating the cost of permanent head count tells you a lot about how efficiently your people make revenue. Unlike fixed costs like rent which is difficult to influence once a rental agreement is signed, profit on head count is one fixed cost business people can improve.

Profit per square foot = net profit (before tax) / square feet of office space 

Which service and/or people are an asset or liability? Changing either is not easy, so it pays to get this right early on. There are several variables the hiring manager needs to factor when deciding how to maximise revenue. Here are a few ways staff cease to be assets and become liabilities.

  • Staff without clear performance guidelines lose focus;
  • Businesses without an organization chart will hire people for the wrong positions;
  • Bonus schemes calculated at the top line may prove to be unaffordable at a bottom line.

Futurebooks is Singapore’s and Hong Kong’s most progressive bookkeeping company. We offer affordable, corporate-level bookkeeping and business planning to businesses with big ambitions. Live chat with us now. Visit www.futurebooks.com.sg.

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