The Most Important Ratio for Your Business

I recently had dinner with a group of fellow business owners to exchange war stories and share our opinions on the current state of the econ
February 10, 2011

I recently had dinner with a group of fellow business owners to exchange war stories and share our opinions on the current state of the economy. Towards the end of the conversation, I asked the group what they thought was the most important financial ratio to calculate for a young, growing business. Several members of the group argued for profitability-based ratios. Others suggested operational ratios or gross margins. This generated some rather interesting discussion. My answer was different: revenue per employee.

Calculating revenue per employee

Revenue per employee takes the company’s total revenues and divides it by the average number of employees during the period of measurement. Suppose, for example, that you are analyzing a company with the following data points for 2010:

  • Annual revenues: $48,000,000
  • Total employees on January 1, 2010: 534
  • Total employees on December 31, 2010: 592

In order to calculate our ratio, we would first take the average of 534 and 592:

(534 + 592) /2 = 563

Then we divided the annual revenue by the average number of employees:

$48,000,000 / 563 = $85,257.55

This company generated over $85,000 on average per employee. Is this important?

Why revenue per employee is important

Measuring revenue per employee (R/E) provides a large amount of valuable -- and actionable -- information.

R/E measures productivity

Productivity measures tell owners how efficiently a company operates. Greater efficiency means that you are doing more with less. For most companies, the largest expense is human resources. The more revenues that can be generated for each “unit” of human resources (i.e. an employee) the greater the efficiency of the company. If your business can generate $450,000 in revenues per employee but your main competitor is able to generate $525,000 per employee, then they are doing a better job of managing what they get in exchange for their human resources expenses.

Comparing revenue per employee

In order to find information on your industry and competitors, the Reuters stock screener provides Revenue per Employee under the “Efficiency Ratios” table available by clicking on the “Financials” tab for a given company. For comparison purposes it provides the same ratio for the company’s industry, sector and for the S&P 500. For reference points, consider the following 2010 revenues per employee:

Monitoring and evaluating with the revenue per employee ratio

If you don’t monitor this ratio, it’s time to start. Add it to your management dashboard and compare your ratio to industry averages and specific competitors. Also use it to enhance your company’s productivity. Use it as a goal setting metric for your managers to ensure that your company continues to operate efficiently.

Limitations on revenue per employee

Revenue per employee is not a “miracle” ratio that can answer every single question for business owners. It doesn’t address the compensation of these employees (are they all paid minimum wage or six figure salaries?). It also doesn’t address the profitability of the revenues being generated by the employees. It can also hide inefficiencies in your sales department since it doesn’t distinguish by function.

Using R/E as a way to measure relative performance across companies at different points in their growth cycles may not provide accurate results. A company that is just starting out and has significant startup capital can afford to ramp up headcount in anticipation of future growth while current revenues remain low. R/E may indicate that this company is performing poorly when in reality it is preparing for future growth.

Some of these limitations can be overcome by modifying the basic ratio to use new definitions for inputs (employees) and output (revenues). It can also be overcome by comparing companies in the same phase of the business lifecycle. Some popular variations are:

  • Revenues per dollar of payroll expenses
  • Revenues per sales department employee
  • Gross margin per employee
  • Net margin per employee

Start with the basic revenue per employee. Determine it for your company, competitors and industry average. After analyzing the results, move on to variations of the formula.

Mike Periu is the founder of EcoFin Media, LLC which develops financial trainingfinancial educationentrepreneurship training and more to small business owners on television, radio, print and the internet.  Over the past ten years he has started three companies and advised over 50 companies on financial strategies including fundraising.  Post your questions in the comments of this article.