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A Simple Guide to Financial Metrics for Business Owners

A basic understanding of financial statements and key financial metrics can help improve your decision-making and business success.
A Simple Guide to Financial Metrics for Business Owners

Most business owners don’t have a background in finance or accounting.

That’s a good thing. Finance and accounting skills, while valuable, are only a small part of running a business. Plus, experts in these fields can easily be hired for their advice and recommendations.

That said, with a better understanding of financial statements and how your business measures financial performance, you can take steps to improve your business and create more value.

There’s nothing to be afraid of with financial statements. It’s all basic arithmetic. Just addition, subtraction, multiplication and division. The risk isn’t that you’ll find it difficult to learn, the risk is that you’ll let this barrier stop you from learning these simple and valuable principles.

To help you become more comfortable understanding and speaking about financial statements, your financial results and important metrics, here’s a guide to financial statements. It also includes a list of the top financial metrics owners, managers and operators need to understand.

What are Financial Statements?

Financial statements are a measurement of the performance and health of a business. Most commonly, the performance over a 12-month period and the current financial health. The three main financial statements are:

  • Profit & Loss Statement (or, Income Statement)
  • Balance Sheet
  • Cash Flow Statement

Let’s run through each one, and look at the key metrics.

But first, let’s look at the simple ways you should look to interpret the results of your financial statements.

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A Simple Way to Use Financial Statements

When analyzing your financial statements you are basically watching for three different things:

  • Performance relative to benchmarks: You’d want to know if the typical profit margin in your business is 20%, and you’re earning 10%. Financial statements can tell you how you’re performing relative to industry standards so you can quickly identify areas for improvement.
  • Changes in key metrics: Big changes in any of your financial metrics indicate that something has happened in your business or market. Seeing from your financials that marketing expenses have doubled is a good reminder to look into the cost and effectiveness of your marketing campaigns. Once you notice a change, positive or negative, you should deep dive into it to look for the root cause.
  • Trends over time: You’ll want to know what’s slowly changing over time in your business or market. If inventories are slowly growing over time, it might be something you want to catch and have a chance to put in place measures to improve inventory management. Monitoring these trends can point to areas that need attention.

When performance lags your benchmark, there has been a positive or negative change or there is a trend in a key metrics, you’ll want to dive into why and then come up with a plan to improve your business performance.

All this information is in your financial statements. That’s why financial statements are super important.

Profit & Loss Statement

This is a statement that summarizes a business’s revenues, expenses, and profits over a period of time.

Also known as the income statement.

Important Financial Metrics in the Profit & Loss Statement

Gross Profit Margin: Measures what percentage of revenue is left after subtracting the cost of goods sold. The cost of goods sold refers to the direct cost of production and does not include operating expenses, interest, or taxes. That means gross profit margin is a measure of profitability for a business or product, without accounting for overheads.

Net Profit Margin: Measures what percentage of revenue and other income is left after subtracting all costs for the business, including costs of goods sold, operating expenses, interest, and taxes. Net profit margin differs from gross profit margin as a measure of profitability for the business in general, taking into account not only the cost of goods sold, but all other related expenses.

Balance Sheet

This is a statement that lists a business’s assets, liabilities, and owners’ equity at a specific point in time.

Important Financial Metrics in the Balance Sheet

Current ratio: The current ratio is a liquidity ratio that helps you understand whether the business can pay its short-term obligations. Specifically, your obligations that are due within one year, so your current assets and liabilities. This means it’s a short-term measure of liquidity and ability to pay your debtors.

Quick ratio: The quick ratio is another type of liquidity ratio that measures a business’s ability to handle short-term obligations. The quick ratio uses only highly liquid current assets, such as cash, marketable securities, and accounts receivables. The assumption is that certain current assets, like inventory, are not necessarily easy to turn into cash, so can’t be used to pay your debtors.

Inventory Turnover: Inventory turnover is an efficiency ratio that measures how many times per period (usually 12-months) the business sold its entire inventory. It gives insight into whether a company has excessive inventory relative to its sales levels.

Debt to equity ratio (or Equity Multiplier): Measures how a business is funded. If all the assets are financed by equity, the multiplier is one. As debt increases, the multiplier increases from one, demonstrating the leverage impact of the debt and, ultimately, increasing the risk of the business.

Asset Turnover: Total asset turnover is an efficiency ratio that measures how efficiently a company uses its assets to generate revenue. The higher the turnover ratio, the better the performance of the company.

Return on Equity: Return on equity (ROE) is a profitability ratio measured by dividing net profit over shareholders’ equity. It indicates how well the business can utilize equity investments to earn profit for investors.

Cash Flow Statement

A statement that captures how cash flow is affected by activities from the balance sheet and income statement, categorized into operating, investing, and financing activities.

Important Financial Metrics in the Cash Flow Statement

Free Cash Flow: Free cash flow is a measure of how much cash the business generates from its operations, after accounting for the capital investments required to maintain the businesses operations. This measure could be positive, meaning cash is available to grow operations, or negative, meaning additional financing would be required to maintain current operations.

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Final Thoughts

There are many other financial metrics you can track and monitor to understand your businesses performance and financial health. The list above is a great starting point. Understanding how these metrics influence your business is a critical business skill for all owners, managers and operators to develop.

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