Business By the Numbers - Part 3 - Operating Ratios

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    By Jim D'Amico

    Jim_NoTie

     Business By the Numbers - Part 2” discussed the importance of tracking your business by using numbers from your Profit and Loss statement to create ratios to “measure your company’s ability to turn sales/revenues into profits, a key ingredient to long term success.”

    The next set of ratios are Operating Ratios drawn from your company’s Balance Sheet and Profit and Loss (Income) statement.  Again we’ll use the information from the Vistage* “Formulas for Success” publication.

    Business Operating Ratio Formula #1:Operating Ratios

    “The following ratios combine information from the Balance Sheet and Income Statement to provide a more sophisticated look at what is happening with the business.

    Business Operating Ratio Formula #2:Gross Margin

    Measures the percentage of every dollar of sales that becomes gross profit.  For example, a gross margin of 40 percent means that you earn 40 cents at the gross profit level for every dollar of sales.

    Gross Margin = Gross Profit / Sales

    Business Operating Ratio Formula #3: Pretax Profit Margin

    Measures how much pretax profit is made for every dollar of sales.

    Pretax Margin = Pretax Profit / Sales

    Business Operating Ratio Formula #4: Sales-to-Assets Ratio

    Measures the amount of sales generated for every dollar of assets employed in the business.  For example, a sales-to-assets ratio of 2.5 means you generate $2.50 in sales for every dollar of assets in the business.

    Sales-to-Assets Ratio = Sales / Total Assets

    Business Operating Ratio Formula #5: Return on Assets Ratio

    Measures how much profit you generate for every dollar of assets.

    Return on Assets Ratio = Pre-tax Profit / Total Assets

    Business Operating Ratio Formula #5: Return on Equity Ratio

    This tells the owner how well their investment in the business is doing.

    Return on Equity Ratio = Pre-tax Profit / Equity

    Business Operating Ratio Formula #6: Inventory Turnover Ratio

    Measures how many times a year you sell your inventory.  If you use sales cost, you must also use inventory cost.  If you use selling price, you must also use inventory selling price.  You can use either one as long as you’re consistent.

    Inventory Turnover Ratio = Cost of Goods Sold / Average Inventory

    Business Operating Ratio Formula #7: Days in Inventory Ratio

    Measures how long, on average, it takes to turn over your inventory.

    Days in Inventory Ratio = 365 / Inventory Turnover

    Business Operating Ratio Formula #8: Accounts Receivable Turnover Ratio

    Measures how many times per year you collect your accounts receivable.

    Accounts Receivable Turnover Ratio = Sales / Accounts Receivable

    Business Operating Ratio Formula #9: Collection Period Ratio (Day Sales Outstanding)

    Measures how often, on average, you collect your accounts receivable.

    Collection Period Ratio = 365 / Accounts Receivable Turnover

    Business Operating Ratio Formula #10: Accounts Payable Turnover Ratio

    Measures how many times a year you pay your accounts payable.  You use the Cost of Goods Sold, since this is the closest representative of what you actually paid for the items represented in Accounts Payable.  If you don’t have inventory or Cost of Goods Sold on your income statement, use Revenue in this calculation.

    Accounts Payable Turnover Ratio = 365 / Accounts Payable Turnover

    Business Operating Ratio Formula #11: Payable Period Ratio

    Measures, on average, how often you pay your accounts payable.

    Payable Period Ratio = 365 / Accounts Payable Ratio

    One of the best formats for gathering and interpreting this kind of financial data is the trailing 12-month (TTM) chart because it allows you to see the trends from month to month and year to year.

    The TTM chart is a rolling annual total tracked monthly.  TTM charts clearly tell you if you’re doing good or bad!  Ordinary monthly charts often mislead and show little other than seasonality.  TTM charts also show historical perspective, a true trend-line on sales, gross profits, or other KPI’s you track.”

    Business By the Numbers Part 4 will feature Sustainable Growth Rate.

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    *About Vistage (from Vistage.com): Since 1957, Vistage has been bringing together successful CEOs, executives and business owners into private peer advisory groups guided by expert executive coaches, known as Vistage Chairs. This assembly of peers & expert leaders makes up Vistage Worldwide, an executive coaching organization.
    From the beginning, our coaching Chairs have been at the heart of what makes the Vistage experience so powerful for so many members. Vistage Chairs are a distinguished group of business leaders who come to us from a wide range of industries. Some have owned businesses, many have been CEOs of domestic and international companies, and all are united by a desire to share their insight and expertise to educate other business leaders in their communities through executive business coaching.
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