Many small business owners believe that data tracking is a key ingredient for success. By keeping tabs on progress and performance, you can distinguish what’s working from what isn’t and make informed decisions about how you use your time and money in the future. But data tracking isn’t as simple as merely calculating different amounts, like sales, profits, or losses.
The kind of data that helps companies grow involves financial ratios, which you can show to business lenders to obtain funding for your next major investment.
Profitability ratios tell you how effectively your business generates income. They provide a clear picture of your business’s financial health by comparing your earnings and expenses throughout a certain time frame. In most cases, the higher the ratio, the healthier the business will be. The three the most valuable profitability ratios are your gross margin ratio, profit margin, and of course, your ROI (return on investment).
1. GROSS MARGIN RATIO
Your gross margin ratio factors in gross profits and net sales to determine how well you sell inventory. Gross profits refer to your total earnings minus the cost of goods sold, or the expenses that go directly towards the cost of operations. To calculate your gross margin ratio, divide gross profit by total revenue.
Let’s say you have $80,000 in gross profits and your cost of goods sold is $60,000. $80,000 – $60,000/$80,000 = 40% Gross Margin.
This means you sell your items for 40% more than their cost. So after paying for these items, you will have 40% of your total revenue left over.
2. NET PROFIT MARGIN
This is the percentage of earnings left over after all business-related expenses have been paid. Subtract these expenses from total revenue and then divide this number by total revenue to find your net profit margin.
$120,000 in total revenue and $100,000 in total expenses, for example, gives you a net profit margin of 20%. In other words, 20% of your business’s earnings turns into profit and the other 80% goes towards business expenses.
Gain from Investment – Cost of Investment/Cost of Investment = ROI. Instead of just a percentage, it might be more helpful to think of ROI as somewhat of a “success rate” in order to see how successful your investment was. Spending $800 on a campaign that made $900 gives you an ROI of 20%. It’s safe to say a 20% success rate sounds a lot more alarming than a 20% profit.
FINANCIAL LEVERAGE RATIO
Financial leverage ratios are used to gauge your ability to manage debt. By examining how much business capital comes from debt and how well your business pays its debts, you can see if a small business loan is effectively growing your business. The three most valuable financial leverage ratios are your debt to asset ratio, debt to service ratio, and interest coverage ratio.
1. DEBT TO ASSET RATIO
This is the percentage of assets financed by borrowed capital. Business lenders prefer a lower debt to asset ratio, since small business loans are designed to increase revenue, not to keep your lights on. Simply divide your total debt by total assets to reveal your debt to asset ratio. This number is much more crucial to your approval than credit score, which will likely have no impact on your application. UCS even offers bad credit business loans, credit card processing loans, and accounts receivable factoring for borrowers with poor or little credit history.
2. DEBT TO SERVICE RATIO
Business lenders place a great deal of importance in your debt to service ratio because it shows how much cash your business has on hand to pay off a small business loan. You can also use this number to figure out how much capital you should ask for, since this amount should be as precise as possible. The business funding experts at UCS, however, will make sure you receive an amount that has worked for similar scenarios in the past.
Divide monthly cash flow by your hypothetical monthly or annual loan payment to reveal your debt to service ratio. The payment section should include interest and principal. A debt to service ratio above 1 indicates that you will be able to make your hypothetical payments without impeding your ability to cover regular business expenses.
UCS bases approval almost exclusively on your cash flow throughout the most recent months leading up to your application. This is why it might be a good idea to cut back on monthly expenses or look for cheaper options before seeking additional business funding.
3. INTEREST COVERAGE RATIO
Your interest coverage ratio is another way to compare debt expenses to profits. You want this number to be on the higher side, because that reflects your profits’ capacity to cover outstanding debts.
To reveal interest coverage ratio, you must first calculate earnings before interest and taxes by adding net profits and tax expenses. Then, divide this number by the amount of interest you’d be paying on a hypothetical small business loan. If your interest coverage ratio is two, that means your business’s profits could pay your debt expenses two times over.
YOUR KNOWLEDGE WILL NOT GO UNAPPRECIATED
Other articles might suggest you need to know several more calculations in order to apply for small business loans, like your debt to equity ratio or debt to income ratio. These ratios are largely based on your own income, as opposed to your business’s. Banks assess your personal net worth or credit score before determining approval but at UCS, we have found that these two factors are not accurate indicators of success.
We do not discriminate against smaller businesses or businesses that do not own expensive assets that can be used as collateral. If your business has a consistent and strong sales record, your previous issues with debt could very well be irrelevant when it comes to deciding your terms. We know your industry inside out, so you can only imagine how much we appreciate people with the same level of knowledge of their businesses!