Common Financial Measurements Explained
Let’s say you’ve been invited to speak at a business investor’s roundtable. The topic is financials, and you have twenty minutes to talk about the fiscal strength of your company. Would you know how to quantify your success? Could you articulate it succinctly?
For most small business owners, financial metrics don’t come naturally. However, many of them can be summed up simply and are easy to understand.
A handful of some of the common ones are explained here:
This ratio measures the portion of every dollar of sales a company actually keeps in earnings. It is useful when comparing similar businesses and is calculated by dividing net income (or net profits) by revenues (or sales).
Return on Assets (ROA)
ROA is commonly used to calculate the profitability of a business. ROA is determined by dividing operating income by average total assets during the same period. Sometimes net income is used in place of operating income to account for taxes, but net income is only appropriate to use if the business is not financed with a significant amount of debt.
Return on Equity (ROE)
ROE measures a company’s profitability and is calculated by dividing net income by shareholder equity. It’s one way of showing how profitable a company is from the perspective of the (equity) owner.
The Quick Ratio shows how readily a business is able to cover its short-term liabilities. It’s calculated by subtracting inventory value from current assets and dividing the result, which should consist primarily of cash, short-term investments and accounts receivable, by current liabilities.
Inventory turnover is calculated by dividing total annual sales by average inventory value. Businesses that depend on selling large volumes of low margin goods or services typically have a higher inventory turnover rate (i.e. grocery stores).
Average Collection Period
Average collection period, typically measured in days, is the time it takes for a business to receive cash payments from its clients and customers. It’s calculated by multiplying the number of days in a period by the average amount of accounts receivables and then dividing the result by the amount of credit sales over the same period.
Earnings per Share (EPS)
This commonly cited metric reveals the amount of a company’s profit that’s allocated to each outstanding share of stock. It’s a measure of profitability that’s determined by dividing net income by average shares outstanding.
Price-Earnings Ratio (PE Ratio)
The PE ratio, another often cited metric, is calculated by dividing market value per share by EPS. This ratio represents the equity value of the company for every one dollar of earnings. Lower business risk or higher earnings growth may explain why one company is valued higher than another in comparable industries.
This ratio is determined by dividing total debt by shareholder equity and is an indicator of how dependent a business is in financing its operations with debt.
Speaking fluently in finance isn’t a prerequisite to running a business. However, the better you understand the language, the better prepared you’ll be to communicate to those who really do.