Every business has one goal which is to earn as much profit as possible by providing solution either by a product or a service. The ability to run operations and manage sales is not enough to ensure the sustainability and growth of business. Ensuring profitability requires efficient decision- making and maintaining financial health along with operations and sales. Monitoring financial metrics and taking decisions in accordance with the current situation indicated by the insights from the metrics is crucial to manage financial aspect of any business. We would be elaborating important financial metrics which every business owner must understand and apply to ensure growth and profitability.
Revenue
Definition: In simple words revenue is the money generated by your business by sales of either goods or services.
Why It Matters: A company whose products or services are performing well in the market would generate more revenue that its peers. Hence, revenue can be used in analysing a company’s position with respect to its competitors.
Calculation: Revenue=Number of Units Sold × Unit Price
Gross Profit Margin
Definition: It is obtained by taking out cost of goods sold from the revenue and dividing the difference by the revenue. The ratio is expressed in percentage which gives the efficiency of a company to convert its resources into goods and services.
Why It Matters: As defined above it indicates the percentage of money that a business or a company retains from its revenue. Higher the percentage greater is the amount that a company actually retains from each dollar of revenue on a unitary comparison basis. Hence a higher gross profit is desired from operations of a business.
Calculation: Gross profit margin = (Revenue – Cost of goods sold) ÷ revenue × 100
Net Profit Margin
Definition: Net profit margin can be understood as the revenue left in percentage of total revenue after taking out all expenses, including cost of selling goods, taxes, interest and operating expenses. It is just ratio of net profit to revenue expressed as a percentage.
Why It Matters: As given in the definition we can observe that it is simply the ratio of net profit to revenue expressed in percentage. It means how much net profit a company is able to extract from the revenue after taking care of expenses, costs, and taxes. Hence this metric indicates the efficiency of a company to manage its expenses from the revenue earned.
Calculation: Net Profit Margin= (Net Profit/ Revenue) × 100
Operating Margin
Definition: Operating margin in simple words is the ratio of operating income which is revenue after taking out the operating expenses like wages and raw material but before paying taxes and interests. It indicates how much profit a company makes after covering the operating costs.
Why It Matters: If operating margin is high, it means that company is efficiently managing operations and controlling operating costs effectively.
Calculation: Operating Margin= (Operating Income/ Revenue) × 10 Cash Flow
Definition: Cash flow represents the flow of cash or cash equivalents in and out of the company through operations, investments and financing activities. A company can only generate value for its stakeholders if the company is able to create positive cash flow and maximize the free cash flow which is noting but the free cash left after accounting for the expenses and capital expenditures.
Why It Matters: Positive cash flows mean the business is generating cash from operations and investments which indicates that company can take care of its financial obligations and can also have a cash buffer to tackle tough times.
Calculation: Cash Flow= Cash Inflows−Cash Outflows
Current Ratio
Definition: Current ratio is a measure of liquidity of a company it is simply the ratio of current assets like cash, account receivables, inventory and other current assets to current liabilities. In simple words current ratio is a comparison between current assets and liabilities which informs analysts and investors about the capability of a company to take care of its current liabilities.
Why It Matters: Current ratio is basically a snapshot of current liquidity of a company. A value less than one indicates trouble in maintaining current obligations and a value greater than one indicates a better short-term solvency for a company.
Calculation: Current Ratio= Current Assets/Current Liabilities
Quick Ratio
Definition: Quick ratio is the ratio of a company’s assets which can be quickly converted into cash and is used to analyse a company’s liquidity and financial health. It indicates how quickly can a company use its near cash assets to take care of its financial liabilities. The advantage of quick ratio is its sensitivity in terms of analysing the short- term solvency.
Why It Matters: A higher value indicates greater liquidity and stable financial health. A lower value indicates less liquidity and hints that the company may struggle while repaying debts.
Calculation: Quick Ratio= (Current Assets−Inventory)/ Current Liabilities
Debt-to-Equity Ratio
Definition: Debt to equity is ratio is calculated to compare the weights of debt and equity in a company. It is mathematically just the ratio of total debt to shareholder’s equity in a company. This ratio is also known as gearing ratio as it gives the idea about leveraging debt to run operations. If this ratio is greater than one it indicates that the company is using debt to run its operations which is a good thing if company is able to generate a positive cash flow.
Why It Matters: If the value of debt-to-equity ratio is higher it means that the company is running its operations majorly on debt which indicates greater risk for investors. However, higher ratio for a company bringing in positive cash flow is a good thing as it is efficiently using debt but higher ratio for a company with negative cash flow is a big red sign for the investors and shareholders. A company with a lower value of debt-to-equity ratio indicates less obligations and financial stability.
Calculation: Debt-to-Equity Ratio= Total Liabilities/Shareholder Equity
Return on Equity (ROE)
Definition: Return on equity in layman’s language gives profit made per dollar on shareholder’s equity. For a fiscal year return on equity is calculated by dividing net income made annually by total shareholder’s equity. The ratio is then expressed in percentage which represents the profit made on the equity capital and is crucial in estimating the capability of the company to turn equity investments made by the shareholders into profit. It is also an indicator of decision-making capability of the management as we are measuring how much a company efficiently gives back to its shareholders as profit.
Why It Matters: A stable and increasing trend in the return on equity value with time indicates how wisely and efficiently the company is utilizing the shareholder’s money and producing stable and sustainable profits for them and hence is creating value for their invested money. A lower and declining value indicates poor decision-making ability of the management to generate value for shareholder’s investment. A declining return on equity value also indicates that the company is losing competitive edge in the market as it is not able to provide the profits for shareholders.
Calculation: ROE= (Net Income/Shareholder Equity) ×100
Conclusion
A thorough understanding of these financial metrics is essential for business owners in United Kingdom. Business owners who have a complete understanding of financial metrics identify issues early and are able to take actions to rectify these issues. When these metrics are monitored and controlled by using various process improvement concepts like pareto analysis and PDCA cycle strategic excellence is achieved in business operations and financial stability is ensured for the business. Acquiring knowledge of these metrics empowers business owners to take charge of financial and strategic aspect of business.
