Financial Calculations That Reveal Your Business's Health

When you're in the weeds of running your business each day, it can be difficult to zoom out and see how well your company is performing. Even one quarter's worth of results can be misleading. Seasonal dips and peaks in demand may make it seem like you're doing better (or worse) than you are. Certain financial calculations, however, can give you a clearer picture of your business's financial health and help you make better decisions moving forward.

Profitability

Profitability is perhaps the most important financial calculation you can make.

"A company's bottom line profit margin is the best single indicator of its financial health and long-term viability," reported Investopedia.

The profit margin indicates how many cents of profit have been generated for each dollar of sales. There are two types of profit margin: gross profit margin, which measures the profitability of a company's sales before considering its operating expenses; and net profit margin, which measures the overall profitability of a company after deducting all of its expenses.

Here’s how to calculate both:

• Gross profit margin = (Gross profit / Total revenue) x 100%.
• Net profit margin = (Net profit / Total revenue) x 100%.

A high gross profit margin indicates that your business effectively converts sales into profit. It demonstrates that you are managing your costs well, pricing your products properly, and/or marketing your products to the right customers.

Liquidity

Liquidity describes whether or not your company can quickly convert its assets into cash to meet its short-term financial obligations. A highly liquid company has ample cash or assets that can be easily sold without a significant loss in value.

"Before a company can prosper in the long term, it must first be able to survive in the short term," wrote Investopedia.

Liquidity can be calculated using the current ratio. The current ratio is current assets (assets that can be converted to cash within a year) divided by current liabilities (debts that need to be repaid within a year).

Current ratio = Current assets / Current liabilities

A current ratio of 1.5 or higher is generally considered a good indicator of liquidity. It shows that the company has sufficient current assets to cover its short-term obligations. However, a very high current ratio could indicate that the company is not using its assets efficiently.

[Read more: 5 Business Metrics You Should Analyze Every Year]

Efficiency

Speaking of efficiency, you also want to check how well your operation is optimizing its resources. Operating efficiency measures how well a company uses its resources to generate revenue. The best calculation to use for this indicator is operating cash flow.

Operating cash flow shows how much cash the business generates from its day-to-day activities. Operating cash flow can be calculated using one of two methods: direct or indirect.

• The direct method: This method directly lists all cash inflows and outflows related to operating activities.
• The indirect method: This method starts with net income and adjusts for noncash items (e.g., depreciation, amortization) and changes in working capital (e.g., accounts receivable, inventory, accounts payable).

Cash flow is a major problem for many small businesses. PYMNTs reports that 60% of small businesses struggle with cash flow management, which can hinder a business’s growth potential and even force a business to go under. Regularly calculating your operating cash flow helps you spot problems in your accounting, invoicing, or bookkeeping.

Solvency

Solvency indicates your company's ability to meet its obligations on an ongoing basis, not just in the short term. The debt-to-equity (D/E) ratio is the best way to calculate your business's solvency. To get this metric, divide your total liabilities by your total equity.

Debt-to-equity = Total shareholders' equity/Total liabilities

A lower D/E ratio suggests a healthier financial position, as it indicates that your business relies less on debt to fund its operations. However, D/E ratios vary widely between industries. You want to see your D/E ratio trend down over time rather than benchmark against a specific number.

Returns

Finally, you want to check that you're effectively making the most of any existing funding or investments you've received to grow your business. Two calculations help assess the efficiency of your business resources:

1. Return on assets = Net profit before tax x 100 / Total assets
2. Return on investment = Net profit before tax x 100 / Equity

A return on assets shows how efficiently a company uses its assets to generate profits. It indicates the profitability of a company's assets relative to their cost. A low ratio compared to industry averages indicates an inefficient use of business assets.

Return on investment, or ROI, measures the profitability of an investment relative to its cost. It is a key indicator of how efficiently an investment is generating returns.

[Read more: Creating a Financial Accounting Report With the Four Basic Statements]

How to benchmark your financial ratios against industry averages

Knowing your numbers is only half the battle. Benchmarking your financial ratios against industry averages gives better context to your business's health and performance.

Banks pay close attention to industry benchmarks, too. Before giving you a loan, a banker will compare your company’s financial ratios to those of others in your industry. Knowing where you stand before that conversation happens puts you in a much stronger position. 

Several trusted sources publish industry averages organized by business type.

• RMA by ProSight publishes Annual Statement Studies using comparative industry benchmark data that comes directly from the anonymized financial statements of small and medium-size business clients.
• Dun & Bradstreet Key Business Ratios provides 14 key business ratios, including solvency, efficiency, and profitability ratios, for over 800 types of businesses arranged by industry categories.
• Bizminer is a paid option that produces industry financial analysis benchmarks across 9,000 unique markets and 10M+ companies. 

Use your NAICS code to find the most specific industry classification available, and where possible, filter for companies of similar revenue or asset size. A financial accountant or your business banker may also be able to provide you with the benchmarks used to assess your suitability for a loan. 

Once you have your ratios calculated and your industry data in hand, the process is straightforward. Use the full range of data, not just the average: A single industry average can obscure a wide spread of performance. Track the same ratios over time to account for seasonality. Checking industry data annually is a good way to make sure you have the right amount of data to go off. 

What financial warning signs mean and when to act

When one of your metrics falls short of the industry benchmark, or if you start to see swings in any of your key metrics in one direction or the other, treat these signs as diagnostic signals. 

For instance, a lower-than-average gross profit margin may indicate that you are charging too little for products or paying too much for inventory or materials. A below-average current ratio might mean you need to tighten up your collections or restructure short-term debt. 

If your accounts payable turnover is lower than the industry average, you may actually have leverage to seek out extended terms from suppliers—a hidden opportunity hiding inside what looks like a weak number.

Cash flow often acts as an early indicator that something is off. “Late payments from clients, difficulty covering payroll, or the inability to pay for necessary supplies are all clear indicators. If your business is consistently tight on cash, this needs immediate attention,” wrote CE Interim Management. “Conduct a cash flow analysis to identify where the bottlenecks are. Consider negotiating better payment terms with clients or cutting unnecessary expenses.” 

Ultimately, consider all your financial benchmarks in context. Compare your metrics regularly to the rest of the industry to understand if a problem stems from a macro-economic or consumer trend, and watch your cash flow carefully for signs it’s time to act. 

How to build a monthly financial health dashboard for your business

A monthly financial health dashboard doesn't need to be complicated. It just needs to show you, at a glance, whether your business is moving in the right direction. 

Start by identifying the five to eight metrics that matter most to your specific business: typically cash on hand, gross profit margin, net profit margin, accounts receivable aging, and your current ratio. Pull these numbers from your accounting software at the same time each month (the first week works well for most owners), and track them side by side with the prior month and the same month last year. 

That second comparison is crucial—many businesses are seasonal, and month-over-month alone can mislead you. If you benchmarked your ratios against industry averages, add a column showing where your numbers sit relative to those benchmarks.

A simple spreadsheet, a one-page PDF, or a built-in report from tools like QuickBooks, Xero, or FreshBooks are all you need for the dashboard. Set up a system that’s easy enough to see in a few minutes where your business needs attention. 

CO— aims to bring you inspiration from leading respected experts. However, before making any business decision, you should consult a professional who can advise you based on your individual situation.

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