Key Financial Ratios You Need to Know When Selling Your Business

Since the onset of the Covid pandemic, things have been really tough for small business owners. First, there were the shutdowns. Then, there were product and labor shortages. On top of all of this, business owners had to learn to adapt their businesses to accommodate the safety of their clients and to overcome each new obstacle. At this point, there are many of you who are just ready to sell and move on. But, how did your business perform last year? Before you answer that question, you’ll need to understand the key financial ratios that might tell a different story. Join me as I detail the key financial ratios you’ll need to know when selling your business.

Follow Along With The Financially Simple Podcast!

TIME INDEX:

• 00:20 – Key Financial Ratios for Your Business
• 01:27 – What is a Key Ratio?
• 03:27 – Gross Profit Margin Percentage
• 06:36 – Net Operating Margin Percentage
• 09:02 – Debt to Equity Ratio
• 10:12 – The Quick and Current Ratios
• 12:28 – Your Return on Equity
• 16:30 – Summary

What Are Key Financial Ratios and Why Do They Matter?

When I ask you how your business performed last year, you might say, “Justin, we set a new all-time sales record,” or “We added a whole new line of products and services.” That’s great! But many of you would say that it was a difficult year. You had to make hard decisions that affected the lives of your team. But if you’re answering that question based on these things, you may not be giving a truly accurate picture. As we continue, we’re going to look at five key financial ratios that will tell the story of your business. But first, what is a key ratio?

According to Investopedia, “Key ratios take data from a company’s financial statements, such as its balance sheet, income statement, and statement of cash flows, and then compare them with other items. These numbers are then calculated together to produce a ratio that represents key aspects of the company’s financial picture, such as liquidity, profitability, use of debt, and earnings strength.” Each key ratio focuses on a specific aspect of your company. This could be anything from your margin to EBIT. Because of this, it’s often necessary to look at several key financial ratios to get an accurate depiction of how your business is doing. 

Similarly, key ratios are a more effective barometer for your company’s performance when they display results over multiple periods. Having data from multiple periods enables you to track your company’s performance over time while uncovering problem areas. But what are the five key ratios you should be tracking and what can they tell you?

Key Ratio #1: Gross Profit Margin Percentage

Gross Profit Margin Percentage is, perhaps, the most important key ratio you can track. In fact, I believe this should be tracked on a monthly basis. Best of all, the calculation is pretty simple. Gross Profit Margin Percentage = (Total Revenue – Cost of Goods Sold) ÷ Total Revenue x 100. So, in our example, the calculation looks like this: (102,007 – 39,023) ÷ 102,007 x 100 = 62%. But what does that really tell us?

In short, Gross Profit Margin Percentage is a tool that shows us what percentage of each dollar of revenue is retained as Gross Profit. You see, I often run into clients that are reporting millions of dollars in sales and revenues but they have a high Cost of Goods Sold (COGS). That’s where the Gross Profit Margin Percentage is going to be very helpful. The higher the number, the better. So, how can you improve it?

First, you should look at your COGS. What are you currently paying? Is there a way to renegotiate a better price point with your vendors and suppliers? Lowering your COGS is one of the ways you can have the biggest impact on your Gross Profit Margin Percentage. Next, examine your own pricing. You must be careful when increasing your pricing, however, as you don’t want to price yourself out of competition with the rest of the market.

Key Ratio #2: Net Operating Margin Percentage

Like Gross Profit Margin Percentage, your Net Operating Margin Percentage can be found using a pretty simple calculation. Net Operating Margin Percentage = EBIT ÷ Sales. Some of you might be thinking, “Okay, Justin, how do I calculate my EBIT?”  To find that, you’ll simply subtract your sales from all costs of being in business (Excluding Capital Costs such as interest, taxes, and dividends). Once you find your Net Operating Margin Percentage, you’ll have a better gauge of how well your business is being managed. Typically, businesses with a high Net Operating Margin Percentage are stronger because of it.

Similar to Gross Profit Margin Percentage, your Net Operating Margin Percentage can be improved through increased revenue. Decreasing your overall costs will also improve your Net Operating Margin Percentage. Many times, business owners can achieve this through expansion. So, if your business is suffering from a low Net Operating Margin Percentage, work on increasing your revenues and lowering your costs.

Key Ratio #3: Debt-to-Equity Ratio

The third key financial ratio business owners need to know when selling their business is their Debt-to-Equity Ratio. Now, as many of you know, I am extremely debt-averse. I just don’t like taking on debt. However, there are times in your business when it makes sense to do so. But you want to be smart about it. You must maintain a healthy debt-to-equity ratio. To determine your debt-to-equity, follow this simple calculation: Total Liabilities ÷ Total Equity.

A lower debt-to-equity ratio means there’s a more conservative financial structure for the company. The more conservative the financial structure of a company, the less risk there is. Now, I’m not going to say debt is bad. There is a time and a place for debt. But the more debt you have, the further your business will be from the conservative financial structure it could have. This creates more risk for your business and could be a deterrent for prospective buyers. On the other hand, actively working to decrease your debt-to-equity ratio reduces your company-specific risk which could grow your business’s value.

Key Ratio #4: Quick and Current Ratios

Number four is really a pair of key financial ratios but they offer two ways to show you one critical factor. The Quick and Current ratios will ultimately tell you if your business has enough assets to cover its liabilities for the current year. If they don’t show enough assets, it could be a sign of trouble on the horizon. But what’s the difference between the two and how do you calculate them?

Quick ratios reflect the liquid assets in your business. They’re called Quick ratios because liquid assets are readily available. You don’t have to sell or convert the asset to turn it into a cash position. Calculating your Quick ratio is as simple as dividing your liquid assets by your current liabilities. 

On the other hand, Current Ratios reflect all assets, including your inventory and equipment. These are items you must sell to become liquid. Still, the principle remains the same. If you had to sell your assets, would it be enough to cover your current liabilities? The calculation is very similar to your Quick ratio calculation. In fact, you simply replace your liquid assets with your current assets. Therefore, the formula should look like this: Current Assets ÷ Current Liabilities = Current Ratio.

Key Ratio #5: Return on Equity

We’ve come to the final key ratio and it’s one that I love. However, it’s also a key ratio that I really don’t see many business owners track. But friends, the Return on Equity key financial ratio can really help keep you sane. As a business owner myself, I know what you struggle with and all of the balls you must keep in the air to have a successful business.

You make sacrifices for your business. In fact, I recently sat down with a client and his wife. He is a business owner and she has done some minor clerical work in the business. Although she has very little to do with the handling of the business, it was something she said that really struck me. As we were going over the financial data, she said, “I feel like our family always takes second place to the needs of the business. Most of us know that feeling all too well. So, what can you do about it?

Track your Return on Equity each month. Your business’s return on equity allows you to compare the return a company is making on its shareholders’ investments compared to alternative investments. When you become frustrated or weary, keeping your eye on your return on equity can be the encouragement you need. But how do you calculate it? Return on Equity = Net Income ÷ Average Shareholder’s Equity. 

Wrapping Up…

Friends, whether you’re planning to sell your business this year or twenty years from now, you must have a plan in place. Putting these five key financial ratios to work in your business is a must. Any potential buyer that comes along is going to look at these ratios. So, you may as well track them yourself. At least then you’re able to do the things that must be done to positively influence your company’s ratios, driving its value.

Look, I know life is hard. Operating a business during a pandemic is frustrating. But life is good. And, with these five key ratios in your tool chest, you can at least make preparing your business for a sale financially simple. Let’s go out and make it a great day!

If you have further questions or need assistance in reviewing the areas of your business that can push your key ratios in the right direction, reach out to us! The team at Financially Simple helps business owners like you incorporate tools like these into their organizations.