From the blog Top 5 Formulas That You Need to Know to Grow Your Business
As a small business owner who wants to achieve growth, your knowledge has to span across different fields of business. That includes the 5 formulas you need to know to grow your business.
Your business can’t be successful if you don’t carefully manage your finances. Handling these aspects is often the biggest challenge for first-time business owners trying to turn their new businesses into success stories.
Whatever stage your own business is in, there are certain financial and accounting equations that can help you make smart business decisions.
If you’re interested in learning how to take your business finances to a whole new level, take a look below at the 5 formulas you need to know to grow your business.
The inventory turnover ratio shows how many times a business has sold and replaced its inventory in a given period of time.
Knowing your company’s inventory turnover rate helps you make better decisions about pricing, manufacturing, marketing and buying new inventory. These are all key reasons to include it on this list of 5 formulas you need to know to grow your business.
Inventory turnover formula
You can calculate inventory ratio by:
- Getting the average inventory by dividing the sum of beginning inventory and ending inventory by two
- Dividing sales by average inventory
Average inventory = (beginning inventory + ending inventory) ÷ 2
Inventory turnover = sales ÷ average inventory
Inventory turnover ratio example
Applying the formula to a real-life example will help you better understand how the ITR works.
Let’s say that your company has:
- $300,000 in beginning inventory
- $400,000 in ending inventory
- $100,000 in sales
In this case, the equation would go like this:
- Average inventory: ($300,000 + $400,000) ÷ 2 = $350,000
- Inventory turnover ratio: $100,000 ÷ $350,000 = 0.29
The ITR of 0.29 is hardly a good result. That means the company needs about three years to sell its entire inventory in one turn.
How to achieve a high inventory turnover ratio
Obviously, you don’t want a low inventory turnover ratio since low turnover slows down your business and keeps it from growing. For high turnover, you need to be aware of the amount of inventory at all times.
To achieve a higher inventory turnover ratio, follow these steps:
- Make an inventory ratio analysis on a regular basis.
- Use a demand-planning software tool to forecast the consumer demand for the products your company sells.
- Use promotions (steep discounts, urgency, bundling the products) to increase the demand.
- Evaluate your pricing strategy by considering all the factors that influence product value (raw materials, staff, expenses, processing costs, competitors’ rates).
- Use an inventory management system.
Return on assets
Next on this list of 5 formulas that you need to know to grow your business is the return on assets (ROA). It’s a profitability ratio that shows how much profit a company can generate from its assets.
This formula measures the efficiency of a company’s management in generating earnings from assets on its balance sheet or their economic resources.
ROA is important to investors as it shows a company’s profitability over multiple quarters and years. It is also useful for comparing your company to similar companies.
Return on assets formula
There are two ROA formulas, and they’re both rather simple:
Net income ÷ average assets for the period = return on assets
This method requires that you calculate net profit margin and asset turnover before calculating ROA. However, in most of your calculations, you will already know these two by the time you get to ROA.
The second version is much shorter.
Net profit margin x asset turnover = return on assets
Depending on the formula you use, you may get slightly different results due to imprecisions caused by decimals truncating. If you choose the first example, try to carry out the decimal as far as possible.
Return on assets example
For this example, we will use the first formula. Let’s say that your company has a net income of $3,000 and average assets for the period of $15,000.
The ROA calculation would go as follows:
$3,000 ÷ $15,000 = 0.2 or 20%
This means that the return on assets ratio for your company is 20% in the given time period. By the way, this is great ROA since the average ROA across industries was 0.8% in 2018.
How to increase your company’s ROA
If you want your business to grow, you need to constantly find ways to keep your company’s return on assets as high as possible.
For a higher ROA, try taking the following measures:
- Reduce asset costs. Monitor asset expenses monthly and reduce inventory costs by renting or leasing equipment when you need it.
- Increase revenue. Try to up your revenue without increasing asset costs. To achieve this, you can improve customer service or explore new market segments.
- Reduce expenses. When you do this, you increase the revenue, which creates a higher return on investment. Keep an eye on excessive payroll expenses, rising materials supplies, and shipping costs.
The contribution margin represents the difference between a company’s total sales revenue and variable costs. This amount is also often used to pay off, or at least contribute to, fixed expenses.
But why is contribution margin one of the 5 formulas you need to know to grow your business?
Well, contribution margin is important for investors as it helps them evaluate how efficiently the company is making a profit. With this information, it becomes easier to manage costs and predict the needed product sales that would result in a profit.
Contribution margin formula
Here is how you can calculate contribution margin with a formula:
Contribution margin = sales revenue – variable costs
If you want to get a contribution margin ratio in a percentage, the formula would look like this:
Contribution margin ratio = (sales revenue – variable costs) ÷ sales revenue
Contribution margin example
Let’s say that your company has $1 million in sales revenue and the following amounts in variable expenses:
- Raw materials: $300,000
- Labor costs: $300,000
- Shipping costs: $100,000
- Utilities: $150,000
The equation would look like this:
$1,000,000 – $850,000 = $150,000
This would make your contribution margin $150,000.
Finally, let’s say that the company’s fixed expenses are $30,000. So, after we subtract this amount from the contribution margin, we can calculate the company’s profit:
$150,000 – $30,000 = $120,000
How to increase the contribution margin
Naturally, it’s in your company’s best interest to have the highest possible contribution margin. There are two ways you can achieve this.
The first is to increase sales by applying the following tactics:
- Expand the product line with new products and services
- Boost the total sales volume of your company
- Raise the cost of goods
- Raise the selling price of products
The second method is to save a lot of money on expenses:
- Use less expensive materials
- Lower product labor costs
- Improve the quality of the product
The break-even point is number 4 on our list of the 5 formulas you need to know to grow your business. It’s a point at which a company’s expenses are exactly covered by its sales.
In other words, it’s a production level where the total expenses are exactly the same as the total revenue for a product.
Calculating the break-even point is a crucial financial analysis tool for business owners. A small business owner can use this formula to find out how many units of products they need to sell to cover production costs.
Break-even point formula
To find your break-even point, you need to use the following formula:
Break-even point (in units) = fixed costs ÷ (price – variable costs)
Break-even point example
Let’s say that your company has the following figures:
- Fixed costs: $100,000
- Variable costs for producing one new product: $2
- The sale price for one product: $12
So, the calculation would look like this:
$100,000 ÷ ($12 – $2) = 10,000
Therefore, your company needs to have 10,000 unit sales to reach the break-even point and cover production expenses. If you manage to sell more than that, you will earn a profit.
How to improve the break-even point
There are two ways you can improve the break-even point: by reducing production costs or increasing the product price. If you manage to sell the same number of units, applying one of these tactics will cause the break-even point to drop.
The best tactic would be to reduce fixed costs and variable costs as little as possible, while also slightly raising the price of a product. The company needs to be careful so the increased selling price doesn’t result in fewer units sold, which would disrupt the break-even point.
Free cash flow
Free cash flow (FCF) is the amount of cash a company has left after paying for capital expenditures (CAPEX). It’s in the company’s best interest to have the highest cash flow possible, as it’s a measurement of its financial performance.
Free cash flow analysis measures the true profitability and financial performance of a business. If a company has adequate cash flow, it can develop new products, reduce its debts, and take other business opportunities that will lead to company growth.
Free cash flow formula
For free cash flow calculation, you need to use an FCF formula that looks like this:
FCF = net cash flow from operations – capital expenditures
But we also need to take into account different types of free cash flow and how they’re calculated.
Free Cash Flow to the Firm (FCFF) represents the ability of a business to generate cash netting of all its capital expenditures. The formula looks like this:
FCFF = cash flow from operating activity – capital expenditures
On the other hand, Free Cash Flow to Equity (FCFE) represents the cash flow available for equity shareholders of the company.
FCFE = FCFF + net borrowing – interest x (1 – tax)
Free cash flow example
Let’s say that your company has:
- $150,000 in net cash flow from operations
- $100,000 in capital investments
By applying the simple FCF formula, we get the company’s free cash flow, which is:
$150,000 – $100,000 = $50,000
In this example, your company has a positive free cash flow of $50,000.
How to improve free cash flow
Naturally, every company wants to have a high free cash flow. To achieve that, it’s best to take the following steps:
- Increase net earnings by increasing sales, increasing pricing, or lowering the tax rate
- Reduce capital expenditures through strategic planning and good project management
- Minimize the use of working capital by lowering your inventory needs and speeding up the collection of receivables
Use these 5 formulas to start growing your business today
When it comes to your business, guessing is never the best option. Instead of risking too much by relying on your gut, use proven finance formulas for business success.
Now you’re equipped with the 5 formulas that you need to know to grow your business. Use them wisely and you’ll see your company grow.