My last two articles covered several ratios you could use to measure and control your business.
I presented three simple “liquidity” ratios and three straightforward “profitability” ratios. These six ratios can help you maximize your business’s value, which is the ultimate goal.
Here’s a quick recap of those two already-mentioned categories:
- Liquidity means you have the cash to pay your expenses.
- Profitability measures how you manage your expenses, use your business assets and drive your return on your investment.
This month’s article will examine four “efficiency ratios” you can use to measure and control your business. This brings our total to 10 ratios!
Efficiency ratios measure how well you’re conducting your business. How fast are you collecting your money from credit sales, and how many times are you turning over your inventory in a given period? What sales levels are generated by company assets?
These ratios help you, as the owner, to keep your business in balance.
- The average collection period ratio measures the turnover of receivables, i.e., how long it takes to collect credit sales dollars.
- Inventory turnover ratio - measures how fast your merchandise is moving.
- Fixed assets to net worth ratio - measures the amount of fixed assets that are part of your net worth.
- Investment Turnover ratio - measures the ability of your organization to generate sales in relation to assets.
Let’s look more closely at each of these ratios.
Average Collection Period
Do you offer credit sales? If so, do you have a clear accounts receivable policy that’s communicated to your customers? Create the standard that works best for you. The longer an account ages, the less chance you have of collecting what’s owed to you. Have you seen a collection table like the one below?
Get this ratio by multiplying your ARs (from your balance sheet) times 365 days/year, then dividing that number by your credit sales for the year. A high ratio means a slow turnover. This could be from bad accounts or other reasons.
A low ratio means you’re collecting your money quickly, or customers are paying faster. Note that it's acceptable to collect within about 10 days of your policy collection period.
Inventory Turnover
This ratio measures how fast your merchandise is moving. A good rule of thumb is about six or seven times.
If you have a lot of inventory, that could mean a number of factors. Perhaps you may have obsolete items or overstocked inventory. It could also mean that you're building up inventory for a big season.
High ratios could mean fast-moving inventory and better liquidity. It could also mean a shortage of inventory.
Fast turnovers generally mean a positive. You can divide your net sales by average inventory to get a certain number of times that inventory turns over.
Fixed Assets to Net Worth
This ratio measures the amount of fixed assets that are part of net worth. It provides an indication of how much capital is tied up in low-liquid assets.
Fix assets like land, buildings, equipment, and other fixed assets are more difficult to liquidate if cash is needed. Keep this in mind.
Investment Turnover
Use this ratio to see how you’re generating sales in relation to assets. Use this ratio only to compare how you stand with other firms in the finishing industry. Divide your net sales by your total assets.
Talk to your accountant about your specific situation. If you’re a little weak in using ratios to measure and control your company, commit yourself to learning, gaining confidence, and mastering ratios. This is a perfect chance to enhance your financial acumen. Remember that the language of business is accounting and numbers. If you find you’re not meeting your numbers, analyze why. Optimize your numbers and accept excellence.
Don’t hesitate to call or text me if you have any questions at 949.338.7141, or email me at jvcastiglia@icloud.com.
Jim Castiglia is the founder of Business Street Fighter Consulting and supports entrepreneurial business owners in their desire to grow and maximize the value of their business. He can be reached by email at JimC@BSF.consulting or by phone at 919.263.1256. Visit www.BSF.consulting
