Health Checkup for your business: Four Business Margins and Ratios you must know
Updated: Jan 6
You received a set of financial statements from your accountant last month and while you get the basics you are not sure how to get more out of these statements. If you are concerned about the health of your business the following four business margins and ratios will empower you to:
· Create more significant goals for your business,
· Ask better questions when meeting your accountant or your banker,
· Understand your business metrics and,
· Motivate your team
Let’s start with the Profit and Loss Statement also known as Income Statement or Operating Statement. This statement provides you with an overview of how much revenue or income the business brought in subtracted by expenses incurred during a specific period. The difference between these two major categories will result in Net Profit (also known as Net Income) or Net Loss for your business from one date to another date. Think of it as a movie about your business activities. Did the movie have a happy ending resulting in Net Profit or did it have an unfortunate turn of events that resulted in a Net Loss?
Revenue or Income can be grouped based on different revenue streams such as Design Fees, Sales of Goods Income, Commission Fees, and Other Income not related to the business such as Interest Income. Expenses can be directly related to the revenue or income earned, such as the cost of goods or services sold and there are also overhead expenses or expenses incurred when running a business such as insurance, rent, and bookkeeping.
Most businesses in Canada report their Profit and Loss Statement on an Accrual Basis. The Accrual basis means that Revenue or Income is reported based on the date your business issues an invoice and not on when your business receives payment from its clients. Likewise, expenses are reported based on the date of your vendor’s bill and not based on when your business settles payment.
These are the two ratios you must know in the Profit and Loss Statement:
Net Profit (Income) Margin: Grab the bottom number in the Profit and Loss report also known as Net Profit or Net Loss amount and divide it by Total Business Revenue or Total Income – exclude Income earned from non-business activities.
Let’s say that you obtained a positive 8%, we would say then that for every dollar that was brought in Sales the business kept 8 cents.
Gross Margin: Grab Total Business Revenue or Income and subtract it by Cost of Goods or Cost of Services Sold. This will give you Gross Profit – or how much money the business made net after expenses incurred directly in the effort of making a sale. Grab the Gross Profit and divide it by Total Business Revenue or Income.
Let’s say that you obtained a positive 55%, we would say then that for every dollar that was brought in Sales the business made 55 cents.
We will look at the Balance Sheet Statement now This is another commonly used statement that has some golden nuggets of information. We’ll briefly define the Balance Sheet Statement for you. This statement reports the business assets, liabilities, and shareholder equity as of a specific date. In comparison to the Profit and Loss Report, this is not a movie type of report but a photograph. It is a photograph of the financial situation of your business on a specific date.
The Balance Sheet is broken into 3 major sections. Assets, Liabilities, and Shareholder’s Equity. The balance sheet must balance. This is to say that Assets must equal or "balance" to the sum of Liabilities and Shareholder’s Equity.
Assets can be very liquid or current like the balances in a chequing account. Assets can also be long-term or non-current like Investments, Equipment, Furniture, and Inventory. Liabilities represent the debt that your business holds. Liabilities are also broken down into current and long-term or non-current liabilities. Examples of current liabilities are credit card balances, CRA balances that are due to be paid in less than twelve months. Non-current or long-term liabilities are loans that are expected to be paid past the twelve-month mark. Shareholder’s Equity represents the investment of the owner in a business -either by income generated in previous fiscal or calendar years or by investing money in common or preferred shares.
These are the two ratios you must know in the Balance Sheet Statement:
Current Ratio or Working Capital Ratio: Grab Total Current Assets amount and divide it by Total Current Liabilities
This ratio measures your business's ability to meet its short-term liabilities when they come due. A high current ratio means that your business is cash-rich which can help if the business has plans of expansion or major purchases. A current ratio higher than 1 is considered acceptable according to the Business Development Bank of Canada (BDC).
Debt to Asset Ratio: Grab the Total Liabilities (current and long-term) and divide it by Total Assets (current and long-term).
This ratio is used by banks to measure how a business's assets are financed. A lower ratio can indicate that your business is able to repay its outstanding debts on time and it can take on additional debt. On the other hand, a high ratio may indicate that the business currently depends more substantially on debt to survive and in turn, it may decrease your business’ chances to get more loans.
In summary, business margins and ratios give you the business owner a greater understanding of how your business is being managed currently. Business margins and ratios help you create realistic goals, have more in-depth conversations with your business advisors such as your accountant and banker, create metrics to motivate your team, and much more. We often emphasize to clients that ratios do not mean much if you have nothing to compare them against, understand and discuss with your advisor the context of those numbers. Once you calculate a margin compare it against a previous period (be it last year, last quarter). Compare it against an industry average or standard if possible. These metrics will help you understand better how your business fares today and how it can improve in the future using these standard metrics.
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