Useful Financial Metrics and Ratios 1

Specific financial metrics are used to analyze productivity, determine return on investment, assess debt levels, and track inventory turnover, among other key indicators. 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 its accounts receivable turnover rate.

Here are a few metrics that can be 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 because less of their money is tied up in production and inventory. If GPM is declining, it is likely due to rising costs and pricing pressure from competitors.

GPM calculations can be utilized in several ways. At least three methods are particularly useful. One method is to simply monitor GPM over time. This helps verify operations and assess a company’s competitive position in the market. Another use of GPM is as a benchmark against other companies in the same industry. For example, if a company sells software, the average GPM typically ranges from 80% to 90%; if it sells groceries, the GPM is probably in the single digits.

GPM can also be used to evaluate individual products. For example, a company sells two products — Product A has a GPM of 70%, and Product B has a GPM of 40%. Since Product B is less profitable, if higher volume doesn’t compensate for the lower GPM, it may make sense to focus marketing efforts on Product A or find ways to reduce COGS on Product B so that the gross profit margin aligns more closely 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 retains (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 tool for comparing companies in similar industries or for comparing a company’s current results against its past results. A rising NPM indicates the company is doing a good job lowering costs and increasing operating efficiencies.

NPM also helps compare results. For example, last year a business had total sales of $40,000 and a net profit of $10,000. The NPM was 25%. This year, sales doubled to $80,000, and net profit rose to $18,000. Although the increase in sales sounds impressive, there’s a concern: the Net Profit Margin dropped to 22.5%. This decline could be due to increased costs outside the company’s control or because operations have become less efficient. While the company did increase net income, profit margins declined.

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.’ It measures a company’s liquidity by comparing current liabilities to assets that can be quickly converted into cash, which explains the term "quick ratio.’

Inventory is excluded from liquid assets, as one of the goals of the QR is to determine whether current liabilities can be paid without selling inventory. Inventory should ideally be sold to generate profits, not just 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 needed to pay off current liabilities.

The Quick Ratio is exactly what it’s called – a quick way to assess a company’s short-term financial health. A company with a QR below 1.0 might struggle to meet its debt obligations without taking drastic steps like selling assets or borrowing more money. Additionally, a low QR poses another problem because lenders are often hesitant to lend to a company with a QR under 1.0; if the company is struggling to cover current liabilities, taking on more debt could only make things worse.

The QR is not an absolute measure of a company’s financial health, but it shows whether a business can quickly access funds within hours or days without having to sell inventory or hard assets. A company with a high QR is relatively solvent and has a built-in buffer against short-term cash flow issues.

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 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 that a credit card sale is not considered "credit" for this metric. Although 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. For example, a company selling products online and accepting credit card payments has no receivables to speak of since they are essentially paid when or even before the product is shipped.

Most businesses specify payment terms that outline how long the customer has to pay the invoice. These terms could be payment on receipt, within fifteen days, or thirty days—whichever makes sense for the business and is acceptable to the customers. If the terms are too strict, some customers might look for another vendor willing to offer more flexible terms.

A typical payment term is expecting payment within thirty days of the invoice date, although many companies aim for fifteen days or less. Even if the company specifies "net 15" terms, meaning payment is due within fifteen days of receiving the invoice, the process can take longer. The company might need several days to generate the invoice, and on the other end, the payment must be processed and deposited into 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 upfront, the receivable for that customer is instantly reduced by 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.