The three critical financial measures business owners can monitor to determine the health of their business – liquidity, profitability and operating ratios – are often overlooked due to a lack of confidence.
Your liquidity, profitability and operating ratios are key indicators of the health of your business now, where it has been, and where it is going.
The majority of business owners I work with haven’t developed their financial confidence or awareness about these important ratios because they are not often explained in plain English. There is a high fear factor about business finance and numbers. Once a business owner understands these three key numbers, it can help them to make important decisions quickly.
Liquidity (or solvency) ratios are important because they assess whether the business abs the cash available at the right time to pay its debts when they fall due.
- The best measure of solvency is the Current Ratio and the Quick Ratio.
- A simple spreadsheet formula can do the maths for you.
- When these ratios are below one and declining, this is an early warning sign of a possible liquidity issue. The business owner needs to have this information to then act decisively to avoid a liquidity crisis or worse – insolvency.
Insolvency is a very serious issue for business owners who are company directors. Company directors have a statutory duty under the Corporations Act 2001 to prevent their company from trading whilst insolvent. Directors can potentially be personally liable for further debts incurred by the company whilst insolvent, so monitoring the Liquidity Ratios is an early warning signal for the business owner, and they can then put in place corrective measures such as:
- business strategy turnaround
- cashflow forecasting
- review product/service pricing
- review expenses.
Profitability Ratios help you to assess the profitability of the business.
- The most important Profitability Ratios are Gross Profit Margin and Net Profit Margin.
- A declining trend in either of these ratios is an early warning signal that profit is being eroded, and eventually cashflow will be affected.
- A simple spreadsheet formula can help you calculate these.
- It’s also important to benchmark these ratios against other businesses in your industry sector, to see how your business is performing in the industry.
Operating ratios give the business owner an insight into how efficiently the business assets, and working capital, are being used. Ratios such as Days Receivables, Days Payable and Inventory Turnover are such important indicators on how efficiently the business is operating.
As with all ratios, it’s the trends over time that are most important – as well as benchmark comparisons to industry norms.
Carmelina Fiorentino, Advisor, Business Foundations