Three Financial Formulas Every Business Owner Should Know

September 4, 2023
The Profit Plot

What gets measured gets managed.

Most people think this quote came from Peter Drucker, the effusively championed management theorist.

It's a quote usually spouted by leaders trying to encourage their teams to pick a key performance indicator and track it, hoping that having a watchful eye on a crucial metric will help the business improve in some meaningful way.

That theory is wrong. And Peter Drucker was probably not the original author of this statement, either.

The earliest version of the quote I could find comes from a paper published in 1956, ironically titled "Dysfunctional Consequences of Performance Measurements," written by one V. F. Ridgway.

"What gets measured gets managed - even when it's pointless to measure and manage it, and even if it harms the purpose of the organization to do so."

You're a small business owner - you have a lot of tasks to accomplish. You can measure the time that you spend getting things done. Using that data, you could concoct a time-management schedule that helps you to be 20% more productive.

But that won't fix your business hemorrhaging cash. It's probably not the best use of your time, either.

If we can measure something, it doesn't mean that managing it will make a difference. We have to measure the right thing in the right way.

We need to be extremely sparing about the things we measure and manage.

Welcome back to The Profit Plot, a podcast where we help small business owners unlock the story behind their profitable business by unpacking one complex financial topic at a time. I am your host, Jeremy Millar.

"Judicious use of a tool requires awareness of possible side effects and reactions. Otherwise, indiscriminate use may result in side effects and reactions outweighing the benefits, as was the case when penicillin was first hailed as a wonder drug. The cure is sometimes worse than the disease."

V.F. Ridgway knew what he was talking about.

Some small business owners focus on one key financial metric: their personal bank balance. How much money can I squeeze out of my business? How big can I build as a symbol of my status and success? How can I get more?

The cure is worse than the disease.

Instead, we must be cautious about the metrics we're tracking and the downstream effects those metrics have on our businesses as a whole. That's why, today, we will review how to calculate three key financial metrics using formulas that every business owner should know.

A financial formula calculates a business's financial information to understand a particular financial concept.

The three we'll be reviewing today are the current ratio, gross profit margin, and return on investment.

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I want to clarify, though, that these are not the only financial formulas in the world that matter. They may not even be the ones you need to leverage to solve business problems! But they are widely applicable and incredibly useful when deployed with good judgment and awareness.

A Current Ratio is one of the simplest financial ratios to understand and an instrumental measurement of your company's liquidity. This ratio focuses on assets and liabilities expected to be converted into cash or called on within one year.

You'll first want to know what your Current Assets are. Current Assets are things like cash or cash equivalents, accounts receivable, and other highly liquid assets.

Then, you'll want to calculate your Current Liabilities. Current Liabilities are short-term obligations that are payable within a year. Things like accounts payable, short-term debt, or accrued expenses are all considered to be Current Liabilities.

To calculate the Current Ratio, you'll take the value of your Current Assets divided by Current Liabilities.

Let's say you're a retailer with $500,000 in Current Assets spread across bank accounts and inventory. Many inventory-based businesses purchase products on credit to preserve cash flow. Your Current Liabilities, including the line of credit you've used to purchase product, is $250,000.

This means your business has a Current Ratio of 2:1 - it's liquid enough to cover the short-term debts you're responsible for paying.

Having enough cash or cash equivalents to satisfy your current liabilities is instrumental in understanding the level of risk that your business is currently under. If you're buried in debt, your Current Ratio may be concerningly flipped.

A highly liquid business is often more desirable to lenders or investors and can help secure working capital if needed.

Of course, this formula is only helpful if you understand what makes up your Current Assets and Current Liabilities. You're in trouble if you have hundreds of thousands of dollars in inventory and very little cash with looming debt payments.

You need to be able to convert that inventory into cash quickly. To know how much you've profited off of the items that you sell, though, you'll need to understand your Gross Profit Margin.

How do you set prices in your business?

Many business owners simply take a guess or pull a number out of thin air when first trying to calculate how things should be priced. It's often a vague calculation of labor or a markup of items that are resold or manufactured into a new product.

Calculating your gross profit margin gives you a percentage of revenue that exceed the cost of goods sold.

To calculate gross profit margin, you'll take gross profit and divide it by revenue. Then, you'd multiply that figure by 100 to get a percentage!

Let's say you're running an enterprise-grade tech company. Your strategy is to sell licenses to customers. Your software relies heavily on hosting infrastructure and API calls between external databases. On average, you estimate software costs to be $15,000 per customer per year.

Luckily, your average yearly contract value is in the realm of $240,000 per year.

To calculate gross profit margin, we'll first need to find our gross profit. $240,000 in sales minus our average yearly cost of goods at $15,000. That's $225,000.

When we take $225,000 and divide it by $240,000, then multiply that figure by 100, we arrive at our gross profit margin of 93.75%. An incredible profit margin.

This means that, for every dollar you receive in sales, you're keeping almost 94 cents to pay for the rest of your company's expenses. These massive profit margins mean that you can reinvest into R&D, hire more engineers, provide better benefits, or distribute profit.

Understanding your gross profit margin helps to determine how you should price your products and services. Different industries have varying profit margin percentages, which can help provide benchmarks on how much your business can keep on average.

Your gross profit allows you to assess the profitability of a potential line of business, a product, or a service. It's an incredibly useful tool to leverage when determining whether or not your business is truly making money on what you're selling.

It's essential to recognize that your Gross Profit is distinctly different from your Net Profit. Gross Profit is a calculation of revenue minus the costs of producing the product or service you're selling, your Cost of Goods Sold.

Net profit will be left over after subtracting all expenses from your top-line revenue, including general and administrative, payroll, and facilities.

Our final financial formula is incredibly popular and incredibly misused.

Return on Investment, or ROI, is a calculation that measures the gain or loss generated on an investment relative to the amount invested.

To calculate ROI, we've got to understand our net profit and divide that figure by the cost of our initial investment. Then, we multiply that amount by 100 to get a percentage.

Let's say you're an SEO agency and you've decided to invest $50,000 in a new marketing campaign that, after a few months, results in an increase of $70,000 in sales. The return on your $50,000 investment is pretty easily calculated!

The net profit of this project was $20,000. We divide that by our initial investment of $50,000, and after multiplying by 100, we arrive at 40%.

ROI is an excellent way to help budget and forecast future investment projects, like the marketing campaign in our example. It's a helpful calculation to quantify the efficiency of an investment and to know whether or not your investment is generating the expected return.

But there are two types of ROI: financial and non-financial. It's much easier to quantify the financial because we can leverage actual data.

ROI becomes a tricky metric to manage because many things business owners do take significant non-financial resources that aren't always easily quantified.

For example, you may have spent hundreds of hours networking, which results in thousands of dollars of new business. The only way to effectively track the ROI of your networking efforts is to quantify the number of hours you've spent and multiply that by the value of your time.

The return on non-financial investments can be much more difficult to track.

To be fair, completely tracking the return on a particular investment without proper segmentation of revenue is next to impossible. Sure, you may have seen a $70,000 increase in sales as in our previous example, but how do you know if that resulted from the marketing campaign you implemented?

You need clear, actionable data in order to measure anything effectively.

Today, we dove deep into the world of financial metrics, challenging the belief that merely measuring something guarantees its effective management.

The Current Ratio is a measure of your company's liquidity. By comparing your current assets to your current liabilities, you get a clear picture of your short-term financial health. Ensure you understand the nature of these assets and liabilities, as not all assets are easily convertible to cash when needed.

Gross Profit Margin helps determine how much of your sales revenue remains after accounting for the direct costs associated with producing your goods or services. It's crucial for pricing decisions and understanding the profitability of specific lines of business.

Return on Investment is a popular yet often misunderstood metric. It measures the efficiency of an investment, but remember that not all investments are easily quantifiable, especially those that require non-financial resources like time and effort.

Just as a doctor wouldn’t rely solely on a single test result to diagnose a patient, business owners should understand and use a combination of metrics to analyze and improve the health of their businesses.

Every financial formula and metric comes with a caveat. You have to measure the right thing in the right way. It's not just about numbers, but the stories they tell.

As always, thank you for tuning in to The Profit Plot. Make sure that you're subscribed to The Profit Plot podcast on Spotify, Apple Podcasts, or wherever else you get your podcasts from. Please share this episode with a fellow entrepreneur who could benefit from rethinking how they measure and manage.

Let's not just track numbers. Instead, let's work towards truly understanding them by diving deeper into the stories our businesses tell, one metric at a time. Looking forward to having you here with us next time, on The Profit Plot.

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Jeremy Millar
Written by:
Jeremy Millar

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