Using Financial Ratios To Increase The Value Of Your Business

First, failure to know the story behind the numbers can prove very costly down the line. Keep in mind that every cent you inject into your business ought to deliver returns that help you meet business expenses, pay salaries, and earn profits.

But how will you ensure that every dollar brings you a profit?

The ideal way is to analyze financial ratios to understand your business liquidity, operational efficiency, and productivity.  Ratio Analysis is the fundamental way of understanding the financial state of your business. 

The process starts by pulling data from your financial statements to compute various financial ratios. With that in mind, here are some of the financial ratios used in assessing business performance and navigating to success. 

 1. Net Profit Margin

To better understand the net profit margin, you first need to understand the net income.

Net income is the amount that remains after deducting business expenses. As business owners, you should check your net profit margin (Net Income / Revenue) because it determines your financial health. Understanding net profits margins can give you insights into how every dollar invested in your business translates into profit.

The Net Profit Margin value is arrived at using the formula; Net Income ÷ Revenue.

Keeping track of the rise and fall in net profit margins helps a company understand the viability of the current business practices.

For example, a company should check if enough profit is generated from the sales and whether the costs are contained. As a business owner, you must ensure that the net profit margin rises faster than operational and overhead costs.

 2. Working Capital

Working capital is the ability of your business to pay liabilities using the current assets.

The working capital value is arrived at using the formula; Current Assets ÷ Current Liabilities.

The ratio depicts financial health and can be used to assess the ability of a company to pay its debts. For example, if a company has a current asset value of $1 million and a current liability value of $500,000, the working capital ratio would be 2:1.

Note that two companies might have the same working capital ratio, but if one has more cash, it would pay its debts quickly and expand the business.

 2. Inventory Turnover

The inventory turnover ratio measures the rate at which inventory is used, sold, or replaced.

In this case, inventory may include all goods (raw or finished) that a business has in stock with the intent to sell. This ratio is calculated by dividing the cost of goods by the average inventory for the same period. A higher ratio translates to strong sales and a lower one to weak sales.

Inventory Turnover = Cost of Goods ÷ Average inventory

This ratio helps to compute the duration needed to sell goods at hand. The inventory turnover tells how fast the goods sell and can help the business owner understand the market demand. And understanding your current demand can help you plan for the future.

 3. Receivables Turnover

How easily can your business liquidate its assets?

The receivables turnover ratio quantifies the effectiveness of a business in collecting money from its debtors. For instance, if a company is efficient in debt collection, it'll have a high receivable turnover ratio.

Receivables Turnover = Net Credit Sales ÷ Average Accounts Receivable

Tracking the business receivable turnover ratio helps assess the impact of advancing goods to clients on credit, and a measure of the business's productivity.

If your receivable turnover ratio is low, you should take appropriate actions to improve debt collection. Effective debt collection contributes to the success of a business venture. 

How to Use Financial Ratios to Make Your Business More Profitable?

The above ratios can help identify and quantify business strengths and weaknesses. Understanding your company's strengths and weaknesses can help you make adjustments that will steer it down a profitable path.

Here are some tips on how to make your company more profitable with financial ratios.

 1. Check on Relevant Ratios

Financial ratios are different, with each offering different business insight.

Depending on your business type, you should identify the ratios that impact your business and analyze them to ensure everything is working as it should.

For instance, if your business keeps raw or finished goods, you should analyze inventory turnover ratios to assess its efficiency in managing stock.

2. Regularly Monitor Results

After analyzing the relevant ratios, compare the results periodically to see the changes in business performance. If you realize a sharp rise in profits and then a decline, try to identify what might have changed and the necessary cause of action.

3. Use Ratios to Drive Strategy

The insights you get from your financial ratios should help you shape the direction of your business. Ask yourself:

• Am I managing stock effectively?
• What do the ratios tell me about debt management?
• Is my business headed in the right direction in terms of profitability?

 Make sure to use the insights from the ratios above to devise a working business strategy.

For instance, if you realize that you have a problem with receivables turnover, adopt better debt collection strategies. If your sales ratios show a backward trend, you may have to dig deeper into the causes and devise strategies to boost sales.

 Wrapping Up

As a business owner, you must aim to make your business profitable at all times.

Financial ratios give you visibility into your business’s performance and help you identify areas that need improvement.

Many things change in the business arena, some of which are imperceptible to the naked eye. Financial ratios offer a great way of evaluating and assessing business performance by comparing various components in financial statements. Analyzing the information revealed by the ratios and evaluating changes over time help make changes that enhance business vitality.