Useful Financial Metrics and Ratios 1
Specific financial metrics are used to analyze productivity, determine return on investment, debt levels, inventory turnover, and more. Which metrics are useful depends at least in part on the nature of a business? For example, a small start-up is not concerned with determining earnings per share but may be very interested in knowing their accounts receivable turnover rate.
Here are a few metrics that can used to analyze operating and financial performance and make smart decisions:
Gross Profit Margin (GPM)
Equation: GPM = (R COGS) / R X 100
R = Revenue
COGS = Costs of Goods Sold
GPM determines the percentage of gross profits a company has made. If the GPM is determined to be 40%, the company made $0.40 for every dollar of sales.
Example: A company sells laser printers. Gross sales last year were $200,000. The laser printers were purchased from a manufacturer and cost the company, including shipping, a total of $80,000.
$200,000 80,000 = $120,000
120,000 / 200,000 = .60, or 60%. The GPM is 60%.
GPM can also help companies understand how efficiently they use labor and raw materials, the lower the COGS, the higher the gross profit margin. Finding a cheaper supplier for a material or product will cause GPM to increase. Additionally, if prices are raised, GPM will increase.
Companies with high GPMs tend to be more liquid since less of their money is tied up in production and inventory. If GPM is declining, it is probably due to risings costs and pricing pressure from competitors.
GPM calculations can be used in a number of ways. At least three methods are very useful. One method is to simply track GPM over time. Doing so sense-checks operations and a company’s competitive position in the marketplace. Another use of GPM is as a benchmark against other companies in the industry. If a company sells software, the average GPM is typically in the 80% to 90% range; if a company sells groceries, the GPM is likely a single-digit percentage.
GPM can also be used to evaluate individual products. Say a company sells two products - Product A has a GPM of 70% and Product B has a GPM of 40%. Product B is less profitable; so, if higher volume does not make up for lower a GPM, it could make sense to focus marketing efforts on Product A, or to find ways to reduce COGS on Product B so the gross profit margin falls more into line with Product A.
Net Profit Margin (NPM)
Equation: NPM =NP/TS X 100
NP = Net Profit
TS = Total Sales
Net Profit Margin indicates the level of profit per dollar of revenue. Net profits are profits on sales after expenses, overhead, and payments on liabilities. NPM measures not just what a company earns but what it keeps (until taxes are paid.)
Example: Total sales for the month are $40,000. Net profit (after expenses) was $4,600.
4,600 /40,000 = .115, or 11.5%. The Net Profit Margin was 11.5%.
NPM is a useful way to compare companies in similar industries, or to compare a company’s current results against past results. A rising NPM indicates the company is doing a good job lowering costs and increasing operating efficiencies.
NPM also helps in comparing results. For example, say last year a business had total sales of $40,000, making $10,000 in net profit. The NPM was 25%. This year sales doubled to $80,000, and net profit increased to $18,000. While the increase in sales sounds great, there’s a problem: Net Profit Margin fell to 22.5%. While that may be due to increased costs that are outside of the company’s control, it could also be due to the fact operations have become less efficient. While the company did manage to increase net income, profit margins fell.
Keep in mind the decrease in NPM may be acceptable. If total sales and total profits rise due to the fact a company intentionally lowered prices, net profit margin will naturally decrease as a result.
Quick Ratio (QR)
Equation: QR= QA/CL
QA = Quick Assets
CL = Current Liabilities
The Quick Ratio is sometimes called the "liquidity ratio" or the "acid test ratio". The Quick Ratio measures the liquidity of a company by determining the ratio between current liabilities and assets that can be quickly converted into cash (and therefore the use of the term "quick ratio").
Inventory is excluded from liquid assets since one of the goals of the QR is to determine if current liabilities can be paid without selling inventory. Inventory should hopefully always be sold to generate profits, not simply to cover expenses.
Example: A business has $40,000 in cash and $20,000 in liabilities.
40,000 / 2,000 = 2.0. The QR is 2.0; the company has double the liquid assets available needed to pay off current liabilities.
The Quick Ratio is exactly what it’s called a quick way to measure the short-term health of a company. A company with a QR lower than 1.0 may not be able to meet debt obligations without taking drastic measures like selling assets or borrowing additional funds. A low QR creates another problem, because lenders are often unwilling to make loans to a company with a QR below 1.0; if the company is struggling to meet current liabilities, adding more debt may only aggravate the problem.
The QR is in no way an absolute measure of business health, but it does indicate whether a company can put its hands on funds in hours or days without having to resort to selling inventory or hard assets. A company with a high QR is relatively solvent and has a built-in buffer against short-term cash flow problems.
Accounts Receivable Turnover (ART)
Equation: ART = NCS/AAR
NCS = Net Credit Sales
AAR = Average Accounts Receivable
Accounts Receivable Turnover indicates the frequency of payment on accounts receivable (money that your company is waiting to "receive" from its customers). Since, in effect, a credit sale is like a loan, the lower the ratio, the slower the customers are paying off their "loans". The higher the ratio, the more quickly the company is being paid.
Example: Last year net sales, based on credit, were $100,000. Payments were not made by credit card; the company invoices for sales made. The average dollar value of receivables at any given time was $25,000.
100,000 / 25,000 = 4.0. The ART was 4.0.
Keep in mind a credit card sale is not "credit" for the purposes of this metric. While the customer is using credit, the company is paid (relatively) immediately. In that case the credit card company is the entity extending credit, and the credit extended is their receivable. So, for example, a company selling products online and taking credit card payments has no receivables to speak of since they are in effect paid when or even before product is shipped.
Most businesses define payment terms stating how long the customer has to pay the invoice. Terms could be payment on receipt, or within fifteen days, or thirty days whatever makes sense for the business, offset by what customers are willing to agree to. If terms are too tight, some customers may find another vendor willing to offer more generous terms.
A typical payment term is the expectation of payment within thirty days of invoice date, although many companies try to maintain terms of fifteen days or less. Even if the company specifies "net 15" terms, meaning payment is expected within fifteen days of receipt of invoice, the entire process may take longer. The company may take several days to generate the invoice; then on the other end of the transaction process the payment and deposit it in the bank, all of which increases the Average Accounts Receivable time.
The goal is to increase ART as much as possible to create more cash flow and more cash on hand to fund operations. ART can also be decreased by requiring initial deposits. If a customer pays 50% of the invoice up front, the receivable for that customer is instantly cut in half.
Investors also pay attention to ART. If ART is ten days or less, investors will generally be impressed by the efficiency of a company’s billing and accounts receivable operations.