When you're in the weeds of running your business each day, it can be difficult to zoom out and see how well your company is performing. Even one quarter's worth of results can be misleading. Seasonal dips and peaks in demand may make it seem like you're doing better (or worse) than you are. Certain financial calculations, however, can give you a clearer picture of your business's financial health and help you make better decisions moving forward.
Profitability
Profitability is perhaps the most important financial calculation you can make.
"A company's bottom line profit margin is the best single indicator of its financial health and long-term viability," reported Investopedia.
The profit margin indicates how many cents of profit have been generated for each dollar of sales. There are two types of profit margin: gross profit margin, which measures the profitability of a company's sales before considering its operating expenses; and net profit margin, which measures the overall profitability of a company after deducting all of its expenses.
Here are the formulas for both:
- Gross profit margin = (Gross profit / Total revenue) x 100%
- Net profit margin = (Net profit / Total revenue) x 100%
A high gross profit margin indicates that your business effectively converts sales into profit. It demonstrates that you are managing your costs well, pricing your products properly, and/or marketing your products to the right customers.
Liquidity
Liquidity describes whether or not your company can quickly convert its assets into cash to meet its short-term financial obligations. A highly liquid company has ample cash or assets that can be easily sold without a significant loss in value.
"Before a company can prosper in the long term, it must first be able to survive in the short term," wrote Investopedia.
Liquidity can be calculated using the current ratio. The current ratio is current assets (assets that can be converted to cash within a year) divided by current liabilities (debts that need to be repaid within a year).
Current Ratio = Current assets / Current liabilities
A current ratio of 1.5 or higher is generally considered a good indicator of liquidity. It shows that the company has sufficient current assets to cover its short-term obligations. However, a very high current ratio could indicate that the company is not using its assets efficiently.
[Read more: 5 Business Metrics You Should Analyze Every Year]
A company's bottom line profit margin is the best single indicator of its financial health and long-term viability
Investopedia
Efficiency
Speaking of efficiency, you also want to check how well your operation is optimizing its resources. Operating efficiency measures how well a company uses its resources to generate revenue. The best calculation to use for this indicator is operating cash flow.
Operating cash flow shows how much cash the business generates from its day-to-day activities. Operating cash flow can be calculated using one of two methods: direct or indirect.
- The direct method: This method directly lists all cash inflows and outflows related to operating activities.
- The indirect method: This method starts with net income and adjusts for noncash items (e.g., depreciation, amortization) and changes in working capital (e.g., accounts receivable, inventory, accounts payable).
Cash flow is a major problem for many small businesses. PYMNTs reports that 60% of small businesses struggle with cash flow management, which can hinder a business’s growth potential and even force a business to go under. Regularly calculating your operating cash flow helps you spot problems in your accounting, invoicing, or bookkeeping.
Solvency
Solvency indicates your company's ability to meet its obligations on an ongoing basis, not just in the short term. The debt-to-equity (D/E) ratio is the best way to calculate your business's solvency. To get this metric, divide your total liabilities by your total equity.
Debt-to-equity = Total shareholders' equity/Total liabilities
A lower D/E ratio suggests a healthier financial position, as it indicates that your business relies less on debt to fund its operations. However, D/E ratios vary widely between industries. You want to see your D/E ratio trend down over time rather than benchmark against a specific number.
Returns
Finally, you want to check that you're effectively making the most of any existing funding or investments you've received to grow your business. Two calculations help assess the efficiency of your business resources:
- Return on assets = Net profit before tax x 100 / Total assets
- Return on investment = Net profit before tax x 100 / Equity
A return on assets shows how efficiently a company uses its assets to generate profits. It indicates the profitability of a company's assets relative to their cost. A low ratio compared to industry averages indicates an inefficient use of business assets.
Return on investment, or ROI, measures the profitability of an investment relative to its cost. It is a key indicator of how efficiently an investment is generating returns.
[Read more: Creating a Financial Accounting Report With the Four Basic Statements]
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