Stories about entrepreneurs always focus on their big ideas, but building a successful business is as much about the details as it is about the central concept. Successful founders not only have a unique vision; they must be diligent in constantly optimizing the efficiency of their business.
One of the first steps in making sure your business is as efficient as possible is to understand how to measure efficiency. Good accounting is important, but financial statements are complex and difficult to analyze. These five ratios can be calculated from your financial statements and can give you a good picture of your businesses' health and efficiency.
The current ratio is simply a company's current assets divided by its current liabilities. Current assets are any assets that the company expects to convert into cash in the next year, while current liabilities are those that the company expects to pay out within the next year.
On a basic level, the current ratio measures a company's ability to pay its bills on time. If your current ratio is near or below 1, your business could be in jeopardy of not being able to pay its creditors, and it might be time to raise more capital. On the other hand, too high a current ratio means you might have capital going unused, and you should consider investing more in long-term growth.
Inventory turnover measures the number of times inventory is sold and replaced within a given period. It is calculated by dividing the average inventory for the period by cost of goods sold. Warren Buffett has emphasized high inventory turnover as one of the key qualities he looks for in an investment.
There are many reasons why high inventory turnover is good for a business. It turns assets into cash more rapidly, making it easier for a cash-strapped company to pay its bills. It reduces storage costs, as inventory is spending less time in warehouses and on the shelves. Companies with high inventory turnover can react more quickly to changing market conditions and adjust their offerings to meet customers' changing tastes.
Most importantly, high inventory turnover allows a company to get the most out of its assets. Inventory can be one of the biggest capital requirements for small businesses, and rapid turnover allows a business to earn lots of money without spending a huge amount on building up inventory.
Gross profit is revenues minus cost of sales, or the cost of manufacturing and delivering your product. Gross margin is simply gross profit divided by revenues, and it measures the difference between what you can sell your product for and how much it costs to make.
Unlike selling and administrative costs, which are more at the discretion of the company, gross margin is all about the efficiency of your operation and the effectiveness of your pricing strategy. If your gross margin is slipping significantly below your competition, it's time to reevaluate your production process and see where there's room for improvement.
Revenue Per Employee
Employee wages are one area of discretionary costs over which an entrepreneur has a good deal of control. Too few employees can lead to poor customer service and lower production capabilities, while too many employees increase expenses and can decrease a company's margins.
Revenue per employee is a good way to measure how much value each employee is creating for your company. If your revenue per employee is significantly below average for your industry, it might be time to downsize and think about how you can accomplish the same tasks with fewer employees.
Return On Invested Capital (ROIC)
ROIC is more difficult to calculate, but it is the most important measure of the long-term profitability of your business. ROIC is calculated by taking the after-tax operating profit of your business and dividing it by invested capital (total assets minus excess cash and non interest bearing current liabilities).
Since ROIC is based on profits, it's not something that businesses in their early growth stages will be looking at too closely. For a more mature company though, maximizing ROIC should be one of the key goals. More profit with lower capital means more money that the business can return to shareholders, i.e. you.