We talked earlier about using Financial Ratios to analyze your business finances. Your financial statements tell you how much profit or loss you have made, and that is useful. But financial ratios compare different parts of the data to give you more insight into how your business is performing. Here are some ratios that will help you.
How much do you need to sell in order to break even – where your income equals your expenses, so you begin to make a profit?
Without over-complicating this, your overall break-even point is calculated by dividing your fixed costs by your gross profit margin.
Breakeven Point = fixed costs/gross margin
If your fixed costs (expenses) are $10,000 and your gross margin is 60% then the sales you need to make to breakeven are $16,666.
A margin shows you what percentage of each sale is profit.
Margin = ((sales – cost of goods sold)/sales) x 100, or
Another way of looking at it is Margin = (profit/sales) x 100
Gross Margin simply means you are comparing total sales and cost of goods sold as distinct from individual products.
The percentage you add to the cost price of a product, to arrive at your selling price is the Mark up.
Mark up = ((sales – cost of goods sold)/cost of goods sold) x 100
Another way of looking at it is Mark up = (profit/cost of goods sold) x 100
People often get these terms confused.
The difference is that Margin is calculated by dividing profit by sales whereas Mark up is calculated by dividing profit by cost. The mark up % will always be higher than the margin %.
For example, if the cost of a product is $10 and you sell it for $15, the mark up is 50% whereas the margin is 33%.
Margin = (($15 – $10)/$15) x 100 = 33%
Mark up = (($15 – $10)/$10) x 100 = 50%
When you look at your Profit and Loss (Income) Statement, you will see that your Gross Profit is equal to your sales less the cost of goods sold. Other business operating expenses are then subtracted to calculate your Net Profit.
This is the percentage of overall sales that ends in gross profit.
Gross profit margin = gross profit/sales x 100
This is the percentage of overall sales that result in profit after deducting business operating expenses.
Net profit margin = net profit/sales x 100
This calculation measures the number of days it takes to collect the cash from sales on credit. The longer it takes to collect the cash, the more cash flow problems you are likely to have, and the more likely that you will have bad debts.
Accounts receivable (Days) = Accounts receivable/ sales on credit x 365
Note: financial statements do not usually show sales on credit as distinct from total sales. You will need to look at your bookkeeping records to make this breakdown.
This calculation measures the number of days it takes to pay your suppliers for good purchased on credit. Making use of supplier terms allows you to use money in other areas of the business. However, extended days will be an indication of the business struggling to pay its debts and can result in a poor credit rating.
Accounts payable (Days) = Accounts payable/cost of goods sold x 365
This is an efficiency ratio that measures how effective you are at turning over your inventory. It shows how many times a business sold or ‘turned’ its average inventory.
The higher this ratio is the better as it indicates how long inventory is being stored.
Inventory turnover = cost of goods sold/((opening inventory + closing inventory)/2) x 100
There are other ratios that your accountant or business adviser may review with you, but these ratios are a good starting point for managing your business.
Ratios differ across industries. However, you get a reasonable idea as to how your business is performing by comparing your financial ratios to a benchmark for businesses in your industry.
A site providing comparative ratios for US businesses is BizStats. In Canada, you can find financial performance data at https://www.ic.gc.ca/eic/site/pp-pp.nsf/eng/home. In the UK, you can try Nibusinessinfo.co.uk and in Australia, you can try https://benchmarking.com.au/ or start with the Australian Taxation Office Small Business Benchmarks that are calculated from tax returns and activity statement information.
Now that we have reviewed the various foundational pillars of business, let’s look at how we use this information to survive and actually thrive in our own business venture.
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