4 ways to strengthen your business using financial ratios
Read time: 4 minutes
Every dollar you spend should deliver returns so you can grow your business, pay your employees and still make a profit. But how can you be sure that’s the case?
According to Stéphanie Bourret, Manager, Technologies Group at BDC, your bank account alone tells only part of the story.
“You need objective ways to measure the performance of your business,” she says. “Financial ratios give you that.”
Financial ratios are calculations based on the information in your financial statements. Bourret lists a few key ratios every business owner should track:
- Net profit margin and gross margin tell you how much profit you are making
- Working capital (also known as current ratio) is a good indicator of how easily you can pay off existing debt and if you have the cash flow needed to expand your business
- Receivable turnover is a measure of business activity and liquidity (how easily you can convert your assets to cash)
- Inventory turnover tells you how fast your goods are selling, which is an indicator of market demand
How do you use these ratios to fine-tune your business? Bourret offers these four tips for entrepreneurs.
1. Determine which ratios are relevant to you
Every ratio gives you a different kind of insight into your business. How you use them depends on your particular goals.
If you’re looking to grow and need to raise capital, for example, your net profit margin will be key. “The more profit you can show, the better your chances are of raising the cash you need,” she says.
On the other hand, if you’ve launched a new product, you’ll want to track your inventory turnover to make sure you’re aligned with demand. “You want to see that the inventory you keep isn’t old news, that people want to buy the product,” she says.
Some ratios are important to specific industries. For example, occupancy ratio is used in the hotel sector, capital adequacy ratio in banking and sales per square foot in retail. The customer lifetime value to customer acquisition cost (CAC) ratio is often used in the tech sector, especially by software as a service (SaaS) entrepreneurs. It’s important to know which ratios give information relevant to your sector.
2. Keep track over time
Once you’ve determined which ratios to use, compare the results over time to pick out trends or changes in your business performance. If your net profit margin climbed regularly for three years and then took a dip, what changed?
- Were your revenues down in one quarter?
- Have your costs gone up?
- Do you need to take any actions?
3. Benchmark your business
You also need to know how your business compares to others in your industry. With ratios, there is no “magic number” a business should strive for—every company and every industry is different.
Knowing the industry average, however, gives you a general sense of where you want to be. Average ratios are also available for complete sectors and companies of comparable size. Use these as benchmarks to see how you stack up next to the competition and to set realistic improvement goals.
4. Use ratios to drive strategy
The insights that come from the ratios you use should shape the direction of your business plan. “Status quo can kill the potential of a business,” says Bourret. “You always want to be adapting and innovating, and ratios can help you do that.”
For example, if you’re not turning over your receivables fast enough, you may have a cash flow problem. You can address that by changing your procedures or company culture to collect payments more proactively. Or if you see your inventory is turning over too slowly, maybe you need to look at your product mix and either add something new or get rid of something old.
Bourret says ratios are a major part of your profit-making arsenal. “Use them right and you end up with more money in your pocket.” If you’re not sure which ones are right for your business, or how to use them, get advice from your accountant or a BDC business advisor. An expert can help you zero in on where you need to focus your efforts.