3 Essential Finance Formulas for Small Business Owners
Hey, I have an important question to ask you, "Am you making money?" I have known so many business owners and managers who feel like they're making money but don't actually know! I've been there before too. Why are we like this?! Maybe it's because it feels out of our depth and it's expensive to ask someone else (financial planner, accountant, etc.).
You don't have to have an accounting degree to answer the question, am I making money? Let's look at three essential formulas to help you gauge your business's financial health and operational efficiency:
How to see if you're making money as a business:
1. Net Profit Margin
What it measures:
The percentage of revenue that turns into profit after all expenses are paid. Aka - what you put in your pocket.
Why it's important:
It shows how efficiently you're managing your costs relative to your revenue.
Formula:
(Net Income / Revenue) x 100
Net Income is the amount your business made AFTER you paid all expenses.
Revenue is the amount of money that came in (sales, appreciation, etc.)
Example:
If your business has a net income of $50,000 on revenue of $500,000, your net profit margin is 10%.
($50,000 / $500,000) x 100 = 10%
What does it mean?
Higher profit margin is better! BUT average profit margins vary from industry to industry and location to location.
Check a ballpark for yourself by Googling "average net profit margin for [BUSINESS TYPE] in [WHERE YOUR BUSINESS IS]
2. Break-Even Point
What it measures:
The point at which total revenue equals total expenses. So it's the dollar amount or number of units of your product/service you must sell in order to break even.
Why it's important:
It tells you how much you need to sell to cover all your costs. It helps you realistically understand your sales goals so you can make a profit.
Formula:
Fixed Costs / (Sale Price per Unit - Variable Cost per Unit)
Fixed costs are you costs that don't change based on the product/service you sell. Examples: rent, salaries, insurance premiums don't change based on how many quesadillas you make.
Variable costs are the ones that are directly tied to making your product or service. Examples: Raw materials, sales commissions, shipping costs, tortillas and chipotle peppers per quesadilla.
Example:
If your fixed costs are $10,000, you sell products for $50 each, and each product costs $30 to make:
$10,000 / ($50 - $30) = 500 units
3. Inventory Turnover Ratio
What it measures:
How many times your inventory is sold and replaced over a period.
Why it's important:
It indicates how efficiently you're managing your inventory. Higher doesn't always mean better, it really boils down to your strategy. If you're in the food service industry, you want this ratio to be high because it means your raw ingredients are being transformed into meals well. On the other hand, if you're in high-end fashion or jewelry, you'll be fine with a lower inventory turnover because your goods won't depreciate or become obsolete very quickly (if at all) and exclusivity can mean more money!
Formula:
Cost of Goods Sold / Average Inventory
Cost of Goods Sold (COGS - which is more fun to say) is a tougher nut to calculate. In its most simple terms, it is Beginning inventory + Inventory Purchases - Ending Inventory; you are calculating how much you had + what else you bought minus what you have now. This is calculated per period - could be a year, could be monthly, it's up to your needs.
For example:
Beginning Inventory: $10,000
Purchases during period: $5,000
Ending Inventory: $3,000
COGS = $10,000 + $5,000 - $3,000 = $12,000
Average Inventory is like a snapshot of inventory levels - let's say per month. You calculate your inventory at the beginning of the month + ending inventory and then divide that number by 2.
For example:
Average Inventory = (Beginning Inventory + Ending Inventory) / 2
For example, if you started the month with $10,000 worth of inventory and ended with $6,000:
Average Inventory = ($10,000 + $6,000) / 2 = $8,000
Example:
If your cost of goods sold is $200,000 and your average inventory is $50,000:
$200,000 / $50,000 = 4 times per year (that your inventory turns over).
Conclusion
Are some of these a lot more work than you want? Yes. But going broke and shifting your life around is much more work and far more painful. It's worth the time investment - and not just once - but periodically.
By regularly calculating and monitoring these metrics, you'll gain valuable insights into your business's financial health and operational efficiency. This information will help you make informed decisions to improve profitability and ensure long-term success.
Citations:
[1] https://www.netsuite.com/portal/resource/articles/financial-management/small-business-financial-metrics.shtml
[2] https://www.delapcpa.com/business-advisory/financial-health-ratios/
[3] https://navitance.com/list-of-bookkeeping-formulas/
[4] https://www.cloonancpa.com/post/10-key-financial-metrics-for-small-businesses
[5] https://www.sableinternational.com/blog/5-key-financial-metrics-small-business-owner
[6] https://www.neat.com/blog/accounting-formulas-small-business
[7] https://www.netsuite.com/portal/resource/articles/erp/supply-chain-kpis-metrics.shtml
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