Four financial metrics you should knowEmma
EBITDA, ROI, NPAT, PDO … Financial metrics: Are they a jumble of letters, or synonyms that can show you how to meaningfully measure the progress of your business?
For those who are unfamiliar with the terms, they can be nothing more than financial mumbo-jumbo. But for those who understand their function, financial metrics are a useful way to determine how your company is faring. With the scores of acronyms competing for your attention, though, where is a good place to start? Which financial metrics will give you a useful look into how you are performing vis-a-vis your competitors and your own company a year ago?
Here are four helpful financial metrics to get you started.
1. Gross profit margin percentage.
Do you want to find out how profitable your sales are, or how much of your revenue becomes gross profit? The gross profit margin percentage is how to do it. This metric expresses your profits as a percentage of the total sales revenues generated. Smallbusines.chrom.com points out that the percentage allows you to compare the profits of businesses of different sizes because the results are measured as a percentage rather than in raw numbers. To calculate:
- Take revenue minus total cost of sales to get gross profit.
- Divide gross profit by total revenue generated.
- Multiply by 100 to get the gross profit margin percentage.
2. Quick ratio.
Also known as the acid-test ratio, this is one of the financial metrics that measures the extent to which a company can meet its short-term liabilities. It is a conservative version of the current ratio, another oft-used liquidity measurement. To calculate:
- Add together: Cash + marketable securities + accounts receivables
- Divide by the company’s total current liabilities
- The answer you will get is a decimal number. That number can be converted into a rand amount. For example, say your answer is 1.4. That means that the company has R1.40 of liquid assets to cover every R1 of its obligations.
3. Accounts payable and accounts receivable days.
Accounts payable is the amount a company owes because it has purchased goods or services on credit from a supplier.
Accounts receivable is the amount owed to that company by customers who bought goods from the company on credit. Accountingcoach.com illustrates it this way:
“Let’s assume that Company A sells merchandise to Company B on credit. (Perhaps the invoice states that the amount is due in 30 days.) Company A will record a sale and will also record an account receivable. Company B will record the purchase (perhaps as inventory) and will also record an account payable.” The illustration brings to light the saying, ‘There are two sides to every transaction.’ “In accounting we also expect symmetry: Company A has a sale and a receivable, Company B has a purchase and a payable.”
To calculate accounts payable days:
- Take your ending balance of accounts payable
- Divide it by your cost of sales
- Multiply by 365
Accounts payable days is one of the financial metrics that can be used to determine whether you are paying your creditors too early or late. Most companies take about 30 days to pay their suppliers (although this differs from one industry to the next). Once you have determined your accounts payable days, compare it with the industry average. If you are paying in 20 days instead of 30, you may want to stretch out your payment periods to improve cash flow.
A similar comparison can be conducted with your accounts receivable days. If your debtors are taking longer than the industry average to pay you, then consider changing your policy to insist on payment to meet the industry average.
Understanding financial metrics
If the mention of these names and formulae make your head spin, The Finance Team can be of assistance. We have a team of qualified, experienced finance executives who can help you determine which financial metrics can best measure the progress of your business. They are available on an ad hoc or interim basis, according to your company’s needs.
Image credit: http://pas-wordpress-media.s3.amazonaws.com/