Understanding your bottom line is critical for business growth and survival. But do you know what drives those financial outcomes? You do not have to be a financial expert to be a successful entrepreneur.
However, if you understand the most important financial metrics, you are likely to go far. Financial metrics can help you build a thriving business even in the face of competition.
There are many financial metrics that business owners should understand. However, the following five metrics are the most important ones in relation to:
- Managing income and expenses
- Understanding your cash flow
- Knowing your return on assets
- Understanding the status of accounts receivable and accounts payable
Luckily you will find these metrics logical and straightforward. This means that you do not have to apply complicated formulas. It is also easy to relate them to your business.
1. Pre-tax Net Income Margin
Knowing this metric is essential because it lets you understand the profit you make from every sale. This number shows how effective you are in managing expenses. A higher margin means better performance. You can use it to adjust expenses without eating much of the revenue.
This is an important metric to lenders because they can evaluate whether you have surplus income to service the debt without slowing down business operations. After all, the primary goal of most businesses is to make a profit.
That being said, there are businesses that forego profit at startup stages and focus more on growth. However, most of them rely on investors’ money rather than profits to fuel growth before the business stabilizes.
The metric is expressed in financial reports as net profit before taxations divided by total sales.
2. Cash Flow Metric
Inadequate cash flow is a big challenge for most businesses in Calgary Alberta. It not enough to have money in the bank at the end of the month, you also need to have a grasp of the cash flow metric. It is important to know how the cash was generated. Is the company getting cash from selling goods and services, borrowing money, or selling business assets?
Again, this is an important metric when considering whether or not to borrow. Since loans increase your business liabilities, you should not borrow to a level where it pulls down the metric to 1:1 or less.
Besides this, you should also have control of operating cash flow. If your business buys an asset such as business equipment, you need to subtract the capital expense or money you used to buy the equipment from the operating cash flow. This is the actual cash that your company has for business operation.
To calculate the metric, define assets and liabilities, and then divide the total assets by total liabilities. The desirable outcome is to have at least twice as many assets than liabilities or a ratio of 2:1. Understandably, it may be difficult to maintain this goal, but a ratio below 1:1 is a danger sign indicating your business does not have the capacity to meet daily operational requirements.
3. Return on Assets
Return on assets is the measure of how much money a company generates from its assets. It can come in two ways; return on capital and return on equity. They all measure the income in relation to the amount used to generate the earnings.
The metric is an indicator of how profitable your company is in relation to the assets you have. It helps you to understand how effective your team is in managing the assets that generating income. Your company should aim at a higher return at all times. Some successful companies have about 30% return each year.
This metric is calculated by dividing the net income by the average total assets and is usually shown as a percentage. The average total assets figure is used in the calculation to take care of seasonal sales fluctuations, purchase or sale of equipment, or inventory changes.
4. Accounts Receivable Days
Accounts receivable aging is important in understanding how fast money flows into your business. It tells your CFO how fast or slow your business receives payments from customers. If you are not receiving payment quickly enough, you may need to arrange for accounts receivable financing.
Accounts receivable days vary by industry. Some businesses offer a 30-day grace period while others give a longer period. Because of the differences, it is usually not easy to evaluate the performance of your business based on this metric unless you have quality industry data to use for benchmarking. You can obtain this data from trade groups, information providers, and surveys. The best data contains information on businesses in your industry, geographical location, and the same size as yours.
Accounts receivable aging is calculated by multiplying the account receivable by 365 days divided by total sales. A lower number is desirable, but this varies by industry.
5. Accounts Payable Days
Like accounts receivable days, accounts payable days will allow your CFO to understand if the business is settling debt too quickly, which means the money could have been invested in the business.
To keep an up to date accounts payables, you need to manage your cash flow, accounts receivable, and income. Accounts payables days will allow you to take advantages of some of the favorable terms such as discounts that suppliers may offer you.
This metric is also important if you are planning to apply for a loan. Staying current will improve your business credit rating. Borrowers consider this important factor.
The metric is expressed as accounts payable multiplied by 365, and divided by cost of goods sold. The ideal accounts payable ratio is a higher number; of course, this varies by industry.
As your business grows, so should your financial metrics, but the above metrics are crucial at all stages of business growth. Remember financial success is critical for your business success.
Capital Now is a financial firm based in Calgary Alberta that supports business owners financially through accounts receivable financing. If you are facing challenges with funding, call Capital Now today.
Also published on Medium.