How to Use Financial Ratios to Reduce Your Business Expenses

How to Use Financial Ratios to Reduce Your Business ExpensesAt some point during your business life, you need to have an in-depth look at your financial structure. No matter what type of business you are running, you need to always pay attention to your financial management and business expenses.

Many businesses don’t take this seriously, and it isn’t a pleasant experience because whenever they have to undergo a financial crisis in their company, they won’t have a backup plan. But, nevertheless, the last thing you want in an emergency is not to have a backup plan.

Well, don’t worry because, in this article, we will show you how you can use financial ratios to reduce business expenses.

How to reduce business expenses with financial ratios

Determine which ratios are relevant for you

Every ratio gives you different insights into the business. How you use and take advantage of them will depend on the type of goals you are trying to achieve. For example, if you’re looking to raise capital and grow as a business, the best bet you have is to seek to increase profits and raise as much cash as you need.

Alternatively, if you just released a new product, you can consider tracking your inventory to ensure you’ve aligned with demands. Your inventory should be filled with products that people want to buy and not out of the trend!

Use financial modeling in Excel test

If you want to make a good hire, consider using a before hiring test for financial modeling test that evaluates a candidate’s ability to create and maintain financial models using Microsoft Excel. This test is excellent because it will help you hire a financial professional who will frequently work with Microsoft Excel.  The covered skills are:

  • Using Excel formulas
  • Finance
  • Valuation
  • Financial modeling in Microsoft Excel

Liquidity ratios (cash to assets)

Liquidity ratios (cash to assets)

Liquidity ratios are how easily assets can be converted into cash that allows you to cover your debts. The current ratio measures your business’s ability to generate money and meet short-term financial goals and commitments.

Additionally, you should consider calculating your working capital ratio, wondering how to do so? First, divide your current assets (cash, receivables, inventory) by your current liabilities (long-term debts, account payables).

After the working capital ratio, think of calculating the quick ratio. The quick ratio allows you to measure how quickly you can access cash to support immediate and emergency situations. The quick ratio divides your current assets by your current liabilities. Any ratio you get above 1.0 is a good score for you.

However, if you score lower, your company may be facing difficulties and can’t take over the opportunity to meet quick cash demands. If you continuously pay your liabilities, this ratio will improve, and above all, to solve the issue of short-term debts, you can consider borrowing long-term. Don’t forget to review your credit policies with your clients and adjust them to collect receivables continuously.

Although having a ratio higher than 1.0 is important, it will depend on your industry. For example, industries with new trends will often lose value relatively quickly. However, these goods still have a high liquidity rate and function easily when your current ratio is around 1.0.

On the other hand, travel companies have high value and deal with work-in-progress inventory, such as extended account receivable terms. Therefore, these types of businesses carefully plan their payment terms, and when we calculate the current ratio, it should be very high to cover all short-term liabilities. The best business travel management companies are super effective at doing this and keep their current ratio much higher, so they don’t have any issues covering their short-term liabilities (costs).

Net profit margin

Net profit margin is the remaining percentage of your revenue after accumulating all of your expenses, including taxes and interest. Many investors will pay close attention to the net profit margin because it shows whether the investment is worth it.

For example, if you have a net profit margin of 15%, it means that for every dollar, you received $0.15 of the profit. If your net profit margin is low, it will only cause many issues in the long term. When you see these issues, you can stop seeing what is causing them. Maybe sales are dropping due to poor customer service, or maybe your employees are stealing your profits! You can never really know until you investigate.

However, if your net profit margin is high, you are on the right path, pricing your products at the correct amount.

EBITDA-assets ratio

EBITDA stands for earnings before interest, taxes, depreciation, and amortization. This type of measurement is used for measuring abilities to generate income. EBITDA is your operating income and helps you find your profit margin divided by the revenue.

It’s a standard calculation that substitutes for pre-tax cash flows and pre-interest from daily operations. It shows you what is left after expenses and how profitable you can be. Comparing EBITDA to a company’s assets allows you to distinguish how much income a company can generate from its property, assets, and equipment.

How can you improve your EBITDA-assets ratio

Boosting your EBITDA to assets ratio involves raising revenue without increasing expenses or strictly having to cut expenses. Increasing your revenues will involve planning better or improving business offerings to gain insights from customers through customer input. For example, try to reduce learning curves in the customer experience and recommend your business to others more frequently. It’ll be more beneficial for you since customers will seek to recommend your business more frequently.

No matter how you do it, increasing your sales volume will always allow you to cover fixed costs, which means a higher profit. Cutting expenses is the primary focus of boosting EBITDA because savings can easily collapse. Moreover, if the business fails to update and review its vendor lists, it may spend more than usual on its inventory and supplies.

So, how can you cut back on expenses? The best way to do so is by analyzing your most basic expenses- internet, telephone, equipment, and more. In addition, there are businesses that you can establish partnerships with that will help you reduce overall expenses.

Efficiency ratios

Efficiency ratios

Efficiency ratios are measured over a period of three to five years. They are considered a method of giving additional insights into your business, such as cash flow, collections, and operational results.

On the other hand, inventory turnover measures how long it takes for inventory to be sold and replaced within the year. You can calculate inventory turnover by dividing total purchases by average inventories in a given period of time. The wrong side of having a low inventory turnover rate is that you’ll lose revenue if your inventory is sitting on the shelf for long periods.

Assessing how your inventory is doing is important because a higher gross profit is earned every time such turnovers occur. This ratio allows you to see where you can make improvements and is an important factor for the success of your business and inventory management. Evaluating your inventory ratio will primarily depend on your industry and its quality. So, the goods you are selling, are they part of the food, fashion, or which industry?

Moreover, you can look at the average collection period that looks at the average number of days a customer will take to pay for your product or service. You can calculate this by dividing receivables by the total sales and multiplying them by 365. Finally, in order to improve how quickly you collect payments, you can try amending your credit policies and collection procedures. For instance, motivate your clients to pay right on time, give them discounts from time to time, and compare your policies to your competitors.

Leverage your ratios

Leveraging ratios provides a solution in the long term and whenever you are using long-term debt to support your company. In this case, debt-to-equity and debt-to-asset ratios are used by bankers to identify how you finance your assets; does it come from your own finances or credit? From a bank’s perspective, the lower your ratio, the better it’ll be for you since it indicates how well you repay your debts and take on new debt in the long term.

Wrapping it up

That’s all for this article. These are our tips on using financial ratios to reduce business expenses. Of course, financial ratios are under-rated, but they are an excellent way of assessing your profit and expense ratios. Moreover, knowing how easily you can convert your assets into cash and keep top-quality inventory management.

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