I don’t think I’m alone when I suggest, that like many small business owners, I didn’t jump into business ownership because I was really excited about small business bookkeeping or accounting. I knew it was part of the deal, but it wasn’t the part of business ownership I was the most jazzed about. Nevertheless, there are important small business financial metrics every business owner needs to know.
Despite the fact that one of my best friends is a CPA and was regularly offering me accounting advice (some of which I actually listened to), like many business owners I know, I thought I had a better handle on the important small business financial metrics than I really did. Looking back, I recognize that with a better understanding of what I didn’t know at the time, my life would probably have been easier.
Understanding your business’ financial metrics, and what those numbers are telling you, is critical to running a successful business, knowing whether or not your business is profitable, or waking up one day to find out you’re on the slow march to insolvency and going out of business.
In addition to being tools to help you successfully run your business, I once spoke with a lender who said, “If I can tell more about a business by looking at the financial numbers than the business owner, I’m not likely to offer them a loan.” In that sense, having a thorough understanding of what your financial reports are telling you also instills confidence in those that work for you, those that offer you credit, or anyone who otherwise helps you to succeed.
5 Important Small Business Financial Metrics You Need to Understand
Understanding key financial metrics is crucial for small business owners to effectively manage and grow their businesses. Here are five important financial metrics they should be familiar with:
- Gross Profit Margin:
- Definition: The percentage of revenue that exceeds the cost of goods sold (COGS). It indicates how efficiently a company is producing and selling its products.
- Formula: (Revenue−COGS)/Revenue×100
- Importance: A higher gross profit margin suggests better efficiency in production and a greater ability to cover other operating expenses.
- Net Profit Margin:
- Definition: The percentage of revenue that remains after all expenses, including operating expenses, interest, taxes, and COGS, have been deducted.
- Formula: Net Profit/Revenue×100
- Importance: This metric provides insight into the overall profitability of the business. A higher net profit margin indicates better financial health and operational efficiency.
- Cash Flow:
- Definition: The net amount of cash being transferred into and out of the business. Positive cash flow means more cash is coming in than going out, which is essential for maintaining day-to-day operations.
- Importance: Monitoring cash flow ensures the business can meet its obligations, such as paying employees, suppliers, and creditors. It also highlights the business’s liquidity position.
- Current Ratio:
- Definition: A liquidity ratio that measures a company’s ability to pay short-term obligations with its short-term assets.
- Formula: Current Assets/Current Liabilities
- Importance: A current ratio greater than 1 indicates that the business has more current assets than current liabilities, which is a sign of good short-term financial health.
- Accounts Receivable Turnover:
- Definition: A measure of how efficiently a business collects revenue from its customers. It indicates how quickly the business is able to convert accounts receivable into cash.
- Formula: Net Credit Sales/Average Accounts Receivable
- Importance: Higher accounts receivable turnover indicates efficient collection processes and suggests that the business has high-quality customers who pay their debts quickly.
Understanding and monitoring these financial metrics can help small business owners make informed decisions, improve operational efficiency, and ensure long-term financial stability.