Many people go to the doctor for a physical checkup every year or so to make sure they are in good health. If you are the owner of a small business, how do you gauge the “health” of your company?
One way is to keep an eye on several metrics that can help you monitor your company’s health in key areas. These metrics commonly take the form of financial ratios that can be compared against other businesses that are similar to yours, or against prior performance periods for your company- a process known as benchmarking.
Commonly Benchmarked Ratios
There are many different metrics you can use to track and benchmark to gauge your company’s financial health. Here are six ratios that are commonly benchmarked for family businesses:
- Current ratio: This ratio measures your business’ liquidity by revealing how many times current assets could be used to pay off current debt. A current ratio of 1.5 to 2.0 is generally considered to be healthy for most family businesses. The formula: current assets/current liabilities
- Debt-to-equity ratio: This ratio gauges your business’ debt capacity, or ability to take on more debt. Your banker will probably want to see a debt-to-equity ratio of less than 2-to-1 before approving a loan request. The formula: total debt/equity
- Accounts Receivable (A/R) days: This ratio will tell you the average number of days it takes to collect your receivables. An average collection period of 45 days or less is generally desirable, but keep an eye on the trend, as a lengthening period could point to cash flow problems on the horizon. Compare your A/R days to your terms of sale to see if your company is enforcing your credit terms. You can also compare A/R days to industry averages to see how your company stacks up against your peers. The formula: (AR/Annual Sales)x 365
- Inventory turnover ratio- This ratio measures how often inventory moves through your warehouse or off your store shelves in one year. Ideal inventory turnover ratios vary among industries, so compare your inventory turnover trends from one year to the next and always strive for improvement. The formula: Costs of Goods Sold/Average Inventory
- Gross and operating profit margins- These metrics will tell you how much money your company is making as a percentage of sales before and after operating expenses are factored in. Gross profit measures profit produced on sales before considering operating expenses, while operating profit measures profit as a function of sales after considering operating expenses. The formulas:
- Gross profit/sales
- Operating income/sales
- Earnings before interest, taxes, depreciation and amortization- Usually referred to by its acronym EBITDA, this ratio is the truest measure of your company’s profitability, since it removes the impact of such financial statement items as interest, taxes, depreciation and amortization. EBITDA is usually measured as a percentage of sales. The formula:
- Combating Complacency
Tracking and benchmarking key ratios like these is one of the best ways to monitor the financial health of your family business. In addition, it will show you how your company is performing relative to your peers, which can help combat complacency and the perception that current financial performance is “good enough.”