5 Important financial parameters for small business

Vijay Sakorikar
Mar 3, 2018
3 min read

1. Current Ratio

Current ratio = current asset/current liabilities.

Take a case of a IT Industry. generally range of this ratio is 1.2 to 1.7. It is 1.2, means for current liability of $1, company has $1.2 available as liquid asset. If this ratio is more than 2, company is very strong financially and should invest to grow top line. If this value is less than one, means for current liability of $1, company has less than $1. This is a problematic situation to run business.

The trend of current ratio must be monitored frequently. If this is declining, take the improvement measures immediately. The most important way to improve the liquidity.

Early invoice submission.
Reduce DSO (Days of Sales Outstanding) by negotiating payment cycle.
Pay off the liabilities. (this is the situation when layoff happens)
Sale unnecessary assets.

2. Account receivables

High account receivables are good and it means your sales team is doing better job. But this is good if you are confident to collect it. Increasing accounts receivable for more than payment period agreed, shows that your company is poor at collection.

You can identify it by dividing account receivable by Net sale. If the pattern of the ratio is tending towards higher values, then this is the time to look at recovery team how do they make strategy to reduce DSO.

3. Cash flow

Cash flow is the net amount of cash moving in and out of a business. Positive cash flow shows that the company has money (liquid asset) to fulfil liabilities and has buffer to face future challenges. Negative cash flow indicates that company does not have sufficient liquids to accomplish the liabilities. In any case net cash flow should not be less that net income over a sustained period, otherwise it could be cause of concern.

4. Profit Margins.

Profit margins are expressed as a percentage. It measure how much out of every dollar of sales a company keeps in earnings. A 10% profit margin, then, means the company has a net income of $0.10 for each dollar of total revenue earned.

Profit Margin = Net profit / revenue

For example, If a company makes $100 revenue and it cost $70 to earn. Profit is $100 – $70 = $30. Profit margin is $30/$100 = 30%. If you are making $10 by investing $1, it means profit is $10 - $1 =$9. Profit margin is $9/$10 = 90%.

The profit margin is your actual earning against each dollar of revenue. This ratio show companies efficiency and performance.

How to improve profit margin (improve revenue and decrease cost)

Reduce rework – Rework is directly hitting you cost. Develop the strategy of doing Right First Time.
Improve productivity per employee. Revenue generation must be at least 2.5 times the employee payroll.
Review your suppliers and get best rate.
Focus on more profitable product or services: Your products or services with the highest gross profit margin are the most important to your business, as they generate more money.
Decrease direct and indirect cost. Find the way to reduce overheads.
List out your profit drivers and rank them before you develop strategy.

5. Return On Investment (ROI)

This is a performance measure used to evaluate the efficiency of investments or to compare the efficiency of investments in multiple projects. ROI measures the amount of return on an investment relative to the investment’s cost. This can be calculated by dividing benefits from the investment by cost of the investment and the result is expressed as a percentage or a ratio.

The return on investment formula:

ROI = (Benefits from investment – cost of investment) / cost of investment

For example, investment in project 1 is USD 10,000 and after a year gain from project 1 is USD 13,900. So, the benefit is USD 3,900 and ROI is 3900/13000 = 30%.

Investment in project 2 is USD 15,000 and after 2 years gain from project 2 USA 20,000. So, the benefit is USD 5,000 and ROI is 5000/15000 = 33%.

Formula for ROI doesn’t have time component. In above example, which project is better for investment? Project 2 look better but it is not. You must consider duration also for calculating ROI. Divide ROI by duration to get actual returns. Project 2 returns 16.5% however project 1 30%.