Financial Metrics: Master the Language of Business
Business owners have access to myriad of metrics and data, but what is important? What financial metrics are the RIGHT metrics to track in order to make smarter business decisions? In this article, we review the most important financial metrics that business owners should track in order to make informed decisions in their businesses.
In a sea of data, it can be challenging to pick out the important markers that indicate a course correction or impending windfall. By tracking these financial metrics, business owners can have a canary in the coal mine or bellwether to give them insights into trends that indicate important changes that can be made to be more profitable.
To make informed business decisions, it is important to track certain financial metrics that can be found in the company’s financial statements. These include the balance sheet, income statement, and cash flow statement. By monitoring these metrics, business owners can gain insight into the financial health of their business.
What are Financial Metrics?
Financial metrics are indicators used to evaluate your business’ financial performance, position, and strengths and weaknesses. Key financial metrics provide key statistics from financial statements to calculate your business’ liquidity, leverage, profitability, and growth potential to help you make key decisions and evaluations to improve financial performance.
Financial Metrics Help CEOs Make Better Decisions
Metrics give you an honest and in-depth look at how your business is operating so you know when and where to make changes to improve your financial position. They can also be used as tools to determine company strengths as well as benchmarks for key performance indicator objectives.
There are an overwhelming number of metrics available to business owners, so it’s important to know what your business goals are and what metrics can achieve these goals.
Core Financial Metrics You Need to Know
Liquidity, leverage, profitability, and growth are core business metrics you can identify on your company’s financial statements to ensure your business is going in the right direction. Being aware of these metrics as your business grows and develops will be critical for long-term success and financial health.
Liquidity Metrics
Liquidity metrics are used to determine if your business has enough cash, or assets that can be easily turned into cash, to pay off short-term bills. By knowing what liquid funds are available you can get a good idea of your company’s short-term financial health.
When determining your company’s liquidity, you’ll use data from your balance sheets. The two key metrics we’ll use for liquidity are working capital and current ratio.
Working capital outlines the funds you have available to pay off your short-term financial obligations. Working capital can also be valuable for planning yearly budgets and being aware of short-term spending capacity.
To calculate your working capital, gather your current assets and liability from your balance sheet and use the formula:
Working capital = current assets – current liabilities
Your working capital should cover your short-term bills and financial obligations. If not, you will need to make some major adjustments or look for external capital to ensure the survival of your business.
Current ratio uses the same data as working capital but provides a ratio to determine short-term financial health.
Current ratio can be calculated with the formula:
Current ratio = current assets ÷ current liabilities
A current ratio that is less than 1 means you may be unable to pay off financial obligations if they were to all be called in in a short time-period. A good current ratio is between 1.2 and 2. A high current ratio is considered a positive for a company. Banks are more likely to extend credit to companies who can demonstrate that they have the ability to pay obligations. If a current ratio is super high, it might show that the company is not using its assets appropriately.
Using liquidity metrics is a great way to get an immediate snapshot of your current financial health. It should be checked often to make sure negative trends or negative liquidity doesn’t go unnoticed.
Financial Leverage Metrics
Leverage metrics tell you if your company is in a position to borrow from lenders or creditors. But before we learn what metrics to look out for, it’s important to know what leverage is and how it impacts your business.
Leverage means you have an increased earning potential with borrowed funds. Business owners often use leverage when they expect to earn more from borrowed funds by an amount that exceeds the cost of borrowing. A smart use of leverage can maximize the profitability of certain investments.
A key thing to note with leverage is that it amplifies losses as well. If your business does not perform the way you expect it to, then you’ll be paying off interest from your credit or loan with the money you need for more urgent issues caused by bad performance.
Metrics such as total debt to assets ratio can give you a good indicator of your leverage potential.
Total debt to assets ratio tells potential lenders if your company can pay off its loan in case the business fails. Basically, it measures the degree of leverage of the company.
Total debt to assets ratio can be calculated by the formula:
Total debt to assets ratio = (short-term debt + long-term debt) ÷ total assets
Total debt to equity ratio shows your company’s financial structure and is similar to total debt to assets ratio except it deals with your ability to pay off long-term financial obligations. This is a common ratio in looking at a firms solvency.
Total debt to equity ratio = total liabilities ÷ total shareholder equity
The optimal debt to equity ratio varies by industry.
Profitability Metrics
Profitability metrics measure your business’ ability to earn. By understanding profitability, you can determine if your company is on track and has growth potential, or if action plans need to be put into place.
Gross profits + margins indicate if your business is producing and selling products efficiently. These metrics show earning ability before your overhead expenses are factored in. Gross profit margin and net profit margins are a good way to single out your product and see if it’s on track.
Profits give you a dollar amount of the amount made during the income statement period, while margins give you results as a percentage.
Gross profits = net sales revenues – cost of goods sold
Gross profit margins = gross profit ÷ net sales revenues
Operating profit + margins indicate earnings from your normal business operations. These metrics provide a snapshot of your profitability with all costs factored in.
Operating profit = gross profit – operating expense
Operating profit margins = operating profit ÷ net sales revenues
Operating profit includes depreciation and amortization, but does not include interest or taxes.
Growth Metrics
Growth metrics determine if your company is falling behind or is in a good position for future financial success. It’s vital to recognize what defines business success for your company, and what growth you should track.
Common indicators for growth include sales revenue, profits, working capital, and your customer base.
A simple way to calculate the growth rate for the previous year can be found in the following formula, but it works for any period.
2022 Revenue – 2021 Revenue = Yearly difference in revenue
Growth Rate = Yearly Difference in Revenue ÷ 2021 Revenue
A business with stagnant sales and profits can’t keep up with inflation. It’s vital to make sure your company is growing in the key metrics listed in this article, so you don’t fall behind.
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Understanding how to use business metrics can make businesses aware of problems as soon as they happen and plan proactively for the future.
Contact us today to learn more about Financial Metrics and how outsourced accounting can help you use your financial metrics to positively transform your business.
