Finance Terms Every Entrepreneur Should Know
So far, we’ve talked about elements of your company’s balance sheet and income statement, how to calculate your net profit and how to find the break-even point. Now we’ll get into the details - how can you use those elements to evaluate the state your business? This is where ratios come into play! The following are useful ratios which illustrate different ways of measuring the success of your business, and will help you with your production planning:
The Profit Margin
Return on Investment
Revenue per Employee
The Profit Margin
This measurement reveals the amount of profit that a business can gain from its sales: the greater the margin, the more profitable the company is.
The net profit margin allows a company to see how much profit can be extracted from sales and is calculated in the following way:
Net Margin: % (Net profit / Total revenue ) x 100
The gross profit margin shows the profit a company makes after all of the cost of sales, including overheads, have been deducted. It is calculated in the following way:
Gross Margin: % (Gross profit / Total revenue) x 100
Both margins are important because companies need to determine how much they will be able to spend on business operations.
Companies can use these ratios to compare themselves to the industry standards. If your company is below the industry benchmark, it is a signal that you either need to lower the production costs or increase the sale price.
Return on Investment (ROI)
ROI is used to measure an investment’s profitability. It evaluates the performance of an investment by dividing net profit by investment costs, which illustrates what profit an investor gets back for every dollar they put in. It is one of the most used ratios by investors: venture capitalists, private equity firms, or individual investors use the ROI to compare companies or projects, to help them decide whether to invest in them or not. It is calculated in the following way:
ROI: % (Net profit / Investment) x100
So if you are pitching to an investor, make sure you know your ROI, and ensure that it is promising! It is one of the first things that they will take a look at.
Revenue per Employee
Salaries and operational costs are two of the largest expenses that you will face when running a business. A company can determine the productivity of its workers by calculating this ratio. The Result can be compared to industry competitors. The following will give you the result:
Revenue per Employee: Revenue % / Number of Employees
There are two useful inventory ratios that can be used to see how well your product is selling.
The Inventory turnover ratio measures how much inventory is sold over a period of time. It is calculated as:
Inventory turnover = Sales/Inventory
Days in inventory indicates the average number of days the company holds its inventory before selling it:
Days in inventory = 365/Inventory Turnover Ratio
There are two main things that entrepreneurs need to know about inventory turnover. If your inventory turnover is too low, that means either you have too much inventory, or your sales are low. Having a high inventory turnover means you have a strong performance in sales, however it could also mean that you’re an inefficient buyer and you don’t have enough inventory to meet demands. You can find out more about inventory turnover by reading these articles:
The current ratio measures whether a company has enough resources to meet its short-term obligations, and can be calculated as follows:
Current Ratio = Current Assets / Current Liabilities
The higher the ratio, the more liquid your company is. However, this is not necessarily desirable. Your ideal current ratio will differ according to your industry, thus you should only compare your current ratio of companies in your industry and your past ratio.
You can interpret the ratio in the following ways:
If the Current ratio = 1: For every dollar you have, you have a dollar of liability in short term, which is not a very good thing. Being around and under 1 is not very acceptable since your company is “illiquid”.
Current ratio = 1 - 1.5: This is the most common current ratio between industries. For every dollar of debt you owe, you have more than one dollar to correspond it. So it’s good. Try to keep your current ratio above 1. Otherwise, you’ll go down fast.
Current ratio = 2: The ideal current ratio is 2 for most enterprises. For every dollar you owe as debt you have 2 to pay it back, so you can easily pay off your debt.
While having a big number as your current ratio may seem like a good thing, it actually indicates that you’re doing a bad job at reinvesting your earnings: You have a big amount of cash and you’re not using it for a new project, an event, an investment. Why would anyone invest in your company when even you are taking the easy path and just keep generating cash by doing nothing innovative?
Find out more about industry-specific current ratios here:
This liquidity ratio measures how quickly a company can pay its liabilities. It differs from Current Ratio because, in quick ratio, inventory is excluded from current assets because the inventory may not sell out quickly. The formula is:
Quick ratio = (current assets – inventories) / current liabilities
Thus, the ratio captures if your company has enough liquidity, which is frequently used by banks, creditors, investors. The ideal ratio would be 1:1 or higher. Find out more about why here:
Financial Leverage (Debt-to-Equity Ratio)
Financial Leverage indicates a business’ financial solvency and its dependency upon borrowings. Calculating financial leverage can help you to determine how reliable your company is, because it is the proportion of debt to equity. The ratio is calculated in the following way:
Financial Leverage: Total debt / Shareholders equity
While debt is a necessary source of funding that helps a business grow more quickly, having a higher leverage means that a business is more exposed to risk. The greater the amount of debt, the greater the risk would be. So, having a “big” number means that you’re financing your business with huge amounts of debt, which is not good news! Optimal D/E Ratio varies between industries, but generally, it is considered to be between 1-1.5.
This sample of ratios is intended to help you better understand the health of your business. While it may seem cumbersome to do the calculations, they are necessary to ensure that your business will be able to successfully operate!