How do you know when your business is succeeding? You might look at the number of sales you make. Or, you could look to your profitability. Maybe you look at the positive reviews your business has online. These data points are great ways to size up your business’s success. Still, you might want to include some commonly used business ratios to get a more complete picture of your business’s performance.
But first, what are business ratios?
Business ratios are calculations that help you sum, sort, or compare the data your business collects.
Some ratios help you understand your business’s financial wellbeing. They might give you answers to questions like these:
- Can I cover my business debts with my current cash flow?
- How quickly am I getting paid for the work I perform?
- How much money (in terms of sales or income) is each of my employees bringing to my business?
Others help you gain insights into your business’s inventory. Here's what you might be asking:
- How long is the period between buying and selling my inventory?
- How many times in a given period (say, a month or a quarter) is inventory bought and sold?
You can also use business ratios to understand the success of your marketing efforts. Here are some questions ratios could help you answer:
- What does it cost to gain a new customer through a given channel?
- How long does it take to earn back what I’ve spent to acquire a customer?
- How does my total marketing spend impact my business’s revenue?
You can perform these calculations at any given time and compare your results to others in your industry. Or, you can record them and track your progress over time. Both of these options are important and can provide you with valuable insights.
Which ratios should I track?
There are no rules on which ratios to use to run your business. You can choose any ratios that help you understand where you are today and whether you’re moving toward your specific business goals. Still, many lenders and expert marketers recommend tracking these popular ratios:
Cash flow to debt
This ratio can help you understand how much of your business’s total debt you can cover by your cash flow in a given period. Creditors often use this ratio to understand how likely you are to cover your interest payments or default on your debts.
Here’s the calculation you can use to find your cash flow to debt ratio:
Cash flow to debt ratio = Cash flow from operations/Total debt
In the numerator, you’ll input your “cash flow from operations.” Find this figure on your business’s cash flow statement.
In the denominator, you’ll input your “total debt.” Calculate this by referring to your business’s balance sheet and summing both your short-term and long-term debt.
Now, divide the numerator by the denominator. When you do, you'll see how much debt you could repay if you allocated all the cash you earned from operations toward that debt.
What is a good cash flow to debt ratio?
In general, the larger the number, the better. Many analysts recommend a cash flow to debt ratio of at least 65% to prove a business can service its debt.
But some say this ratio should not approach 100%. This can indicate that your business is risk-averse, borrowing too little, or missing out on the possibility of larger returns.
Net profitability can help you understand two important pieces of information: whether you’re generating enough profit from sales and whether your costs are in check.
By putting these two pieces of information together, lenders, investors, and others can compare the performance of multiple businesses and obtain a quick snapshot of each one’s financial health. The ratio is used to understand how much profit each generates from every $1 of sales.
The calculation you’ll use for net profitability is:
Net profitability = Net income/Revenue
In the numerator, you input the revenue your business earned in a period (usually one year or one quarter) minus the cost of goods sold, operating expenses, other expenses, interest, and taxes. You can find this information on your income statement.
In the denominator, you’ll input the revenue your business earned in that period.
While this formula can help you understand your financial well-being. Still, it has some limitations. Namely, it can be easily skewed by the sale of a large asset or a large one-time purchase. It also fails to address sales or revenue growth or factor in how well you’re managing the costs of running your business. For these reasons, you should pair this ratio with others, including the gross margin ratio and operating margin. We cover those ratios below.
What is a good net profit margin?
Ideally, your net profit margin will match or exceed others in your industry. Need to improve yours to keep pace? Find ways to cut costs in smart ways, realize economies of scale, and make sales without engaging in excessive spending to do so.
The gross margin ratio can help you understand the revenue you earn after covering your costs of production. Many owners use this formula to assess how much capital they can keep from each sales dollar their company earns. In your business, you might use this margin to cover other obligations or enjoy as profit.
The formula to calculate gross margin is:
Gross margin = Net sales – Cost of goods sold
Here, you’ll tally your net sales by inputting your revenue for a given period and subtract direct labor costs and other costs associated with producing your company’s products or services.
What is a good gross margin?
A 10% gross margin is considered average in most industries, and a 20% gross margin is considered to be good.
Operating margin can give you insights into the profit you earn on every dollar of sales after covering your variable production costs. It can help you understand how efficiently your business generates profit through its operations rather than from investing or other moneymaking practices.
The formula for operating margin is:
Operating margin = Operating earnings/Revenue
In the numerator, you’ll input your business’s earnings before interest and taxes (EBIT), which you can calculate by subtracting your cost of goods sold (COGS) and other costs not related to interest or taxes from your revenue for a given period.
In the denominator, you’ll input your revenue for a given period.
Operating margin is less useful as a one-time indicator of financial health than it is to track your progress over time or to compare your standing to others in your industry, especially those with similar sales and business models.
What is a good operating margin?
Many owners target a 15% operating margin, which is considered to be good in most industries. However, the ideal operating margin varies by industry. In all cases, the higher the result, the better.
You can use a quick ratio to understand your business’s ability to cover its short-term debts with cash or cash equivalents (any asset you hold that can be converted to cash quickly).
The formula to calculate quick ratio is:
Quick ratio = (Current assets – Inventory)/Current Liabilities
In the numerator, you’ll sum all of your business’s current assets and subtract away inventory, which often cannot be sold quickly enough at their market value to cover today’s debts.
In the denominator, you’ll tally all of the debts you owe in the near term (usually within one year).
By working through this calculation, you’ll find an answer to this very important question: What could I pay off today using all the cash at my disposal?
What is a good quick ratio?
A quick ratio that equals one indicates that you have the precise amount of liquid assets needed to cover your current liabilities. Results higher than one indicate that you have more than enough assets to cover those obligations.
|If your quick ratio is greater than one, you may consider eliminating some of your debts today. Talk with your accountant about whether this is a smart move for your business.|
However, if your quick ratio is less than one, you may not have the capacity to cover your short-term debts and will likely need to make moves to raise capital.
Accounts receivable turnover
If you’re interested in measuring how efficiently your business collects on the credit it extends to its customers, the accounts receivable turnover ratio is your go-to tool. Often, business owners use this ratio to examine the number of times in a year that a business collects its average accounts receivable.
Average accounts receivable is an imprecise calculation that looks at two data points: the total accounts receivables you documented at the start of a year and the total accounts receivables you recorded at yearend. You can find the average with this calculation:
Average accounts receivable = (Beginning accounts receivable + ending accounts receivable)/2
You’ll insert your result into the accounts receivable turnover equation using this formula:
Accounts receivable turnover = Net credit sales for the period/Average accounts receivable
In the numerator, you’ll input how much credit you extended to your customers from the start of the year to its ending, focusing only on sales in which the payment was collected at a later date. Net credit sales is often calculated with this equation:
Net credit sales = Sales on credit – Sales on returns – Sales allowances
In the denominator, you’ll insert the result you arrived at for the average accounts receivables equation.
What is a good target for accounts receivable turnover?
Rather than trying to attain a precise result, your goal should be optimization. This means matching or attaining a slightly higher result than what’s standard in your industry. Good accounts receivable turnover ratios indicate that you have both effective credit policies and solid collection practices.
It’s important to note that your accounts receivable turnover ratio can be too high. Often, this occurs in businesses that offer terms that aren’t in line with the market. Work with your accountant to find a target ratio that suits your business and industry and implement practices to optimize it.
You can use the inventory turnover ratio to understand how efficient your business is in selling the goods it has on hand. It’s often expressed as the number of times a company sells and replenishes its inventory over a given period of time (usually one year).
Most businesses experience spikes in sales over a year, which can make it difficult to create apples-to-apples comparisons. To overcome this issue, you can find your average inventory turnover for the year with this equation:
Average inventory = (Beginning inventory + Ending inventory)/2
Of course, you can also use your ending inventory for a period if your business experiences relatively steady sales or if you want to compare your successes through spikes or downturns.
Next, insert your average inventory or ending inventory into the following equation to find your inventory turnover ratio:
Inventory turnover ratio = Cost of goods sold/Average or ending inventory
To find your cost of goods sold, you’ll need to tally the total direct costs involved in producing your product. Your bookkeeping software may help you with this calculation, or you can work with your accountant to compute it for your business.
What is a good target for inventory turnover?
In most instances, you’ll want to aim for an inventory turnover ratio between 5 and 10, but the precise figure will vary by industry. For instance, high-volume, low-margin businesses tend to have higher inventory turnover ratios than those that are low volume and high margin.
Ratios within this range usually indicate that a business is experiencing strong sales and is clearing its stock efficiently. But, sometimes, seemingly good numbers hide operational issues. For example, inventory turnover can appear healthy in businesses that aren’t buying enough inventory, which can limit their sales.
Take steps to ensure your business is operating in a healthy, sustainable way, and then measure and monitor this ratio to observe your standing.
Sales per employee
Sometimes called “net income per employee,” this ratio is one of the tools you can use to determine the efficiency of your staff. It works best in people-intensive service businesses, such as banks, retailers, and similar organizations that depend on people-facing employees to ensure the business’s success.
The formula to calculate sales per employee is:
Sales per employee = Annual sales/Total number of employees
This formula can help you set benchmarks for what your employees are producing and when you might need to ramp up or pull bank on hiring.
What is a good target for sales per employee?
While there isn’t a single best number to hit with this ratio, high numbers are optimal. High sales per employee outcomes indicate that a business is running efficiently with the number of people they have on staff. Conversely, dips in this number can indicate a problem. Perhaps your employees need more sales training, or you may find you have too many employees on hand. But often, dips can correlate with economic conditions, changes in product demand, or other factors beyond your employees’ control.
By monitoring this ratio, you can spot signs of trouble and begin looking for remedies before your business’s long-term health becomes in jeopardy.
Customer acquisition cost (CAC)
One of the buzziest metrics to track is customer acquisition cost (CAC), and for good reason. With this metric, you can calculate and set a baseline for how much it costs to win a customer (one who purchases your products or services).
Many businesses track their CAC for every marketing effort they make. This may mean capturing CAC for running banner ads, Facebook campaigns, pay-per-click advertisements, and every other investment they make in marketing to their target audience. But you can also benefit from tracking your CAC for your total marketing spend,
The formula to calculate CAC is:
Customer acquisition cost = Marketing spend /Number of customers acquired
In the numerator, you’ll tally what you spend on marketing, sales, and other efforts to reach prospects and secure their business.
In the denominator, you’ll record the number of people you persuaded to make a purchase.
By tracking this equation over time, you’ll have a metric to test your lead conversion efforts and see which marketing initiatives are most worth the effort.
What is a good target for CAC?
Customer acquisition costs vary widely by industry, company life stage, business model, and region. However, a recent Shopify study reported the following average customer acquisition cost by industry:
- Business and industrial: $533
- Furniture: $462
- Electronics and electronic accessories: $377
- Clothing, shoes, and accessories: $129
- Home and garden: $129
- Health and beauty: $127
- Arts and entertainment: $21
These benchmarks can be helpful, but they won’t paint the full picture of the success of your marketing efforts. For that, you’ll need to explore the next ratio, customer lifetime value.
Customer lifetime value (LTV)
Customer lifetime value (LTV) is a metric that captures the total worth of a customer to a business over the entirety of their relationship. For businesses focused on retention, this calculation is useful for learning how much revenue a customer could generate for your business and keeping your team focused on optimizing service to foster loyalty and reduce churn.
The formula to calculate LTV is:
LTV = (A customer’s average purchase value x Their average number of purchases) x Their projected lifespan with the business
For this equation, you’ll determine your customer’s average purchase value with the following formula:
Average purchase value = The customer’s total spend in a period/Number of orders they made during that time
You’ll also calculate average purchases using this formula:
Average number of purchases = Total number of purchases the customer has made/Number of years the customer has been with your business
|If you’re calculating the LTV of a new customer, you might opt to use the purchase frequency rate of existing customers with a similar buying persona.|
Finally, you’ll input your customer’s projected lifespan with your business by modeling them after similar customers you’ve served.
With this calculation in your toolkit, you’ll be able to discern which customers spend the most with your business, stay with you for the longest period of time, and warrant the highest investment of marketing and service dollars to retain their loyalty.
What is a good target for LTV?
Marketing experts often recommend an LTV that’s at least three times a business’s CAC. Here, a business that spends $50 to win a new customer should expect the customer to have an LTV of $150 or more.
CAC and LTV are often used in conjunction with one another. Used together, they help owners compare the value of a customer over their lifetime with a business to the cost of acquiring them.
You can use the formulas provided in the sections above to calculate LTV/CAC, but CFI offers this alternate:
LTV/CAC = [(Revenue per customer – Direct expenses per customer) / (1 – Customer retention rate)] / (Number of customers acquired / Direct marketing spend)
With this formula, you’ll be able to determine whether your marketing strategies create long-term value for your business or are costing too much to be worth the effort.
What is a good target for LTV/CAC?
Ideally, your ratio should be greater than 3. However, new businesses or businesses expanding to new markets often experience lower LTV/CAC ratios while they work on building recognition. As long as the ratio is greater than one (one being a breakeven on cost to revenue creation), there is some hope of creating value for a business.
Sticking with the importance of CAC, it can help to find how long it will take to recover what you invest in acquiring a new customer through the revenues they generate. Here, you’ll want to examine the number of months it'll take to recover your costs rather than finding a ratio.
The formula you’ll use is this:
CAC payback = CAC / Average monthly recurring revenue x Gross margin percentage
Most marketers advise using three-month averages for each of these inputs and tracking this calculation over time. This is especially when you're making changes to your customer acquisition model.
What is a good target for CAC payback?
Small numbers are best. Many startups have CAC paybacks of 12 months or more, and this is ok initially. But you’ll want to take steps to shorten your payback period. You might do this by shifting your investments to your lowest-cost acquisition channels, focusing on retention alongside acquisition, and setting up subscription models to keep generating sales in a low-cost way.
You may also want to track the performance, impact, and profit of your marketing campaigns. This will help you learn what works, what doesn’t, and where you might spend your marketing dollars in the future to maximize your return.
The formula to calculate marketing ROI is:
Marketing ROI = (Sales growth – Organic sales growth – Marketing cost) / Marketing cost
This calculation is a bit simplistic because it doesn’t account for external factors that can impact success. However, by applying it consistently, you can gain a good data point to help you gauge the success of your marketing strategies and pursue new ones.
What is a good target for this ratio?
A good marketing ROI is 5:1, and an exceptionally good one is 10:1.
There are many other operations, sales, and marketing metrics you can use to gauge your business’s success. Work with your accountant or hire a fractional CFO to find the ones that make the most sense for your business to track.
Would you like to connect with a fractional CFO? Take a look at a few of our favorite firms:
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