In the previous part of this article, we looked at the benefits of understanding your accounts. Now we move on to some of the more common ratios. Your accounts are the primary documents, but you need to dig deeper. Ratios are useful for this. We will give some of the more common ratios in each area, and more detail of one of these. There are many more - you could spend your whole business life on ratios, so it is crucial to select the ones most relevant to changes in your business. There's a whole subject of Key Performance Indicators which develops this further.
Ratio examples
COMMON LIQUIDITY RATIOS
Current Ratio (aka Working Capital Ratio)
Quick Ratio (aka Liquid and Acid Test ratio)
Cash Ratio
Now I want to have a closer look at just a few of the more useful ratios and briefly explain what they are about.
First, Liquidity Ratios. Financial ratios in this category measure your business’s capacity to pay its debts as they come due.
A business should always have enough current assets, for example, stock, work in progress, debtors and cash in the bank, to cover its current liabilities such as the bank overdraft, creditors and so on. Liquidity ratios indicate the ability of the business to meet liabilities with the assets available.
Measuring Liquidity: Current Ratio.
Formula Current Assets / Current Liabilities.
Tells you if your business can meet its current debt by measuring if it has enough assets to cover its liabilities.
The Current Ratio is one of the liquidity measures. It answers the question, ‘Does the business have enough current assets to meet the payment schedule of current liabilities, with a margin of safety?’ Carry it out, and hopefully it will come in at 1 or above because a 1:1 current ratio means the company has $1.00 in current assets to cover each $1.00 in current liabilities.
This ratio should normally be between 1.5 and 2. Some people argue that the current ratio should be at least 2 on the basis that half the assets might be stock. If it is declining over time you could be heading for insolvency.
A current ratio can be improved by increasing current assets or by decreasing current liabilities. Steps to accomplish an improvement can include paying down debt; acquiring a long-term loan, selling a fixed asset or putting profits back into the business.
On the other hand, too high a Current Ratio may mean that cash is not being utilised optimally. For example, the excess cash might be better invested in equipment.
COMMON EFFICIENCY RATIOS
Inventory Turnover
Accounts Payable Turnover Ratio
Asset Turnover
Accounts Receivable Period
Efficiency ratios are also referred to as Asset Management Ratios. They are indicators of how efficiently the business is managing its assets. Naturally, it’s to your advantage to make the best use of your assets to keep down costs. You can determine how efficiently your business uses its assets, and where there's room for improvement, by looking at these ratios. In effect, they show how good the management of the business is.
Measuring Efficiency: Days In Receivables.
Formula Average Accounts Receivable / Sales x 365
The average number of days it takes to collect your accounts receivable – how long it takes to turn profit into cash.
Compare your terms of payment with the actual collection period - if they’re not equal, perhaps early payment discounts or advance payments may be needed or some customers should be dropped.
Consider as an example the Days In Receivables Ratio.
Accounts receivable are dollars due from customers, and this ratio shows the average number of days it takes to collect your cash after making a credit sale. The lower the figure the better – you are getting your receivables in quickly.
But say you are tracking it month by month, and it starts to lengthen out – what’s going on?
A longer than normal period may mean you have an increasing number of overdue and uncollectible bills.
If you extend credit for a specific period (say, 30 days), this ratio should be very close to the same number of days. If it's much longer than the established period, you may need to alter your credit policies, for instance by introducing early payment discounts or requiring payment in advance.
It's also wise to develop an ageing schedule to gauge the trend of collections and identify slow payers. Slow collections (without adequate financing charges) hurt your profit since you could be doing something much more useful with your money, such as taking advantage of discounts on your payables. This can even lead to you dropping some customers as being more expensive than they are worth to you.
This is a classic example of how analysing your financial statements can help you spot unfavourable trends before they become a crisis.
COMMON PROFITABILITY RATIOS
Return On Equity
Net Profit Margin
Gross Profit Margin
Return On Assets
COGS To Sales
Profit Mark Up
Since the most important objective for a business is to make a profit, then arguably the most important ratios are those concerned with profitability. Gross profit needs to be sufficient to cover all the overhead costs as well as provide an income for the owner and something to reinvest in growing the business. The business will also need to generate sufficient cash to repay outstanding loans. So knowing what is happening to profitability is important.
Measuring Profitability: Selling, General & Admin. Expenses / Sales
Formula S, G & A Expenses / Sales
Percentage of selling, general and administrative costs to sales
A steady or decreasing percentage indicates that a business is controlling its overhead expenses.
The SG&A / Sales Ratio is an indicator of how well you are handling the costs that impact on profitability. It is a measure of your overhead or fixed costs. The smallest number wins in this category because a low ratio suggests a company is controlling its operating costs very tightly. An increasing ratio means costs are cutting into profitability and could be a reason to look at processes within the business.
COMMON SOLVENCY RATIOS
Debt To Equity Ratio
Debt To Assets Ratio
Equity To Assets Ratio
Solvency ratios are indicators of the businesses' vulnerability to risk. These ratios are often used by creditors to determine the ability of the business to repay loans.
Of course, we all carry debt and need to – it’s not necessarily a bad thing. But it can put a business at risk if it gets out of hand – and it will impact your ability to secure further loans since lenders look at this ratio when they are trying to decide what the chances are of you being able to make good on your business loans and obligations.
Measuring Solvency: Debt To Assets Ratio.
Formula Debt / Equity.
Comparison of how much of the business was financed through debt and how much was financed through equity
The higher the ratio, the greater the risk to a lender
Too much debt can put your business at risk... but too little debt may mean you are not realising the full potential of your business -- and may be hurting your overall profitability
The Debt To Assets Ratio gives a good indication of where you stand. The data comes straight from your balance sheet.
A healthy company has a good balance between its assets and its debt. The more debt you have the higher the ratio and the worse off you are – you will find it hard to ride out a rough time. A good ratio is 1:2 or 50%. Anything over 2.0 and bankers start to get jittery. You might too – it could be you are at risk if anything interrupts your income stream even for a short period.
Using Ratios
Financial ratios can be used as a snapshot of the business - compare your ratios against industry-wide figures to see how you rate (benchmark)
Financial ratios can be used as a moving picture - track them over time to show trends
Let’s leave actual financial ratios there. Of course, that's only a few general examples of how they work, but you see the point – unless you are tracking the ratios you don’t see a problem coming soon enough to be able to look at the reasons and figure out a way of dealing with it.
In other words, the reason for financial ratio analysis is so that you can use the information to help your business grow, increase profits and keep out of trouble.
Now let’s look briefly at a couple of different contexts you can use them in.
Financial ratios can be used as a snapshot of the business or as a moving picture. In the first instance, you can take your ratios and compare them against industry-wide figures to see how you rate. That’s benchmarking. As well, you can track them over time to show trends – that’s the moving picture view.
Financial ratios can be useful to assess how you are performing in comparison to other similar businesses.
If your business isn’t performing as well as it should be in the industry you need to be asking ‘How come?’
Using Ratios For Benchmarking
Financial ratios can be useful to assess how you are performing in comparison to other similar businesses.
If you find that your business isn’t performing as well as it should be in the industry - for instance you are waiting an average of 50 days for bill payment whereas your competitors are getting there’s paid on average at 30 - then you need to be asking ‘how come’
And when you start asking ‘how come’ you are getting down to managing your business. You can even identify some of the better-performing businesses and analyse how they operate to achieve what they do.
There are several sources of benchmarking information available - start with your trade association, they often offer this kind of data to members.
Using Ratios For Trend Analysis
Comparing them over regular time periods, trend analysis is essential to the most efficient management of some processes such as inventory control.
This approach is essential to manage some processes such as inventory control, marketing campaigns and even scheduling your employee’s holidays so that they don’t make holes in your workforce just when demand is high for production or services.
To identify a trend in your financial situation you need to create a baseline against which to compare current ratios. That can be done using your past balance sheets.
Becoming Financially Literate.
Becoming the master of your business's financial fate is not difficult:
- A little knowledge of the main ratios;
- Some discipline in analysing what they are telling you;
- Turning those raw numbers from your company’s financial statements into information that will help you to better manage your business.
Becoming the master of your business's financial fate is not difficult - with a little knowledge of the main ratios and some discipline in analysing what they are telling you, you can turn those raw numbers from your company's financial statements into information that will help you to better manage your business.
I’m a great believer in the idea that every business should have a business plan and a set of forward-looking goals expressed in quantitative terms, for example, sales projections, production figures and so on.
When you run your business like that, then having these figures will allow you to manage it by using your financial statements as a business decision-making tool – you’ll be able to recognise danger signals and assess where the problem is coming from.
And of course, your accountant is always there to help you select the ratios useful to your business, explain how to use them and suggest solutions to the problems that are showing up.
Reporting
Your financial report can be just a couple of pages with some pertinent figures, but it is important to have them produced regularly to track trends. Some ratios need reporting monthly or even weekly, others you might only do once a year, like inventory ratios.
Just think about the car dashboard gauge idea again. Their value is that they change as things are happening – you monitor them regularly as you drive, and you can see the changes. But say they were not gauges, but warning signals and an alarm went off only when a critical condition occurred. That approach reduces your ability to plan your way out of the situation. Well - getting regular financial reports is like that – the difference between having gauges to regularly monitor the situation and just having, say, an end-of-year report that gives you a crisis signal too late.
Mind you, the signals can just as easily be good, like knowing there’s enough cash to pay off some debt, run a marketing campaign or even safely offer your employees a raise. That’s just as worth knowing. But to safely make any of those decisions you should have the supporting numbers first.
Interpreting: Context
The key point about ratio analysis isn’t to get the ‘right answer’ – it’s to understand if the answer is good or bad news. For example, say that a business' profit is 10% of turnover. Is that good or bad? There is no ‘right’ answer – there’s only ‘why is it 10%; is that reasonable; could it be better?’ To do that look at your financial ratios in the context of:
- What they have been in the past – are they getting better or getting worse? Even small changes of 1% or 2% in the gross profit margin for instance can affect a business severely. After all, if your profit margin drops from 5% of sales to 4%, that means your profits have declined by 20%.
- Your business goals and strategies. Here you need to recognise that a change in strategies, such as your pricing strategy (for example moving from a cost leadership strategy to a differentiation strategy) will affect such things as your profit margin and asset turnover ratios.
- The industry norms – as I mentioned ratio analysis is a great way to benchmark and see how you measure up against other businesses.
- And prevailing economic conditions - maybe the times are just against them getting better at the moment.
Interpreting: Comparing Apples To Apples
Benchmark sensibly - when you are comparing your company’s performance to others in the industry, be sure to consider variable factors such as location, size of operations, and intensity of competition.
When comparing we must be sure we are comparing like with like. For example, seasonality will influence the pattern of your ratios - comparing fourth-quarter performance to third-quarter performance might not be as accurate an appraisal as comparing comparable quarters year-to-year.
Similarly, even though I have praised benchmarking, it needs to be done sensibly; when you are comparing your company's performance to others in the industry, be sure to consider variable factors such as location, size of operations, and intensity of competition.
Turning Figures Into Actions
Part of financial intelligence also has to do with putting some thought into what is causing the figures before jumping to conclusions and trying remedies. Figures do need analysing for exact causes.
Yes, receivables days may be on the rise indicating that your customers are taking longer to pay. But is that because they are wilfully ignoring your terms because they have found faults with your product and are delaying payment till their issue is resolved, or because there’s been a general downturn in the economy? Different reasons require different strategies to deal with them – if it’s because of wilful refusal then you could look at stepping up your collection practices, or putting tighter limits on the credit you extend to your customers; if it’s a quality issue then quality assurance procedures need to be addressed.
Or, yes, there is a decreasing profit margin but is it indicating that the balance of your sales mix has changed (you may be selling more lower-margin products and fewer higher-margin products) or have costs of production got out of control?
Figures do need analysing, but without the figures there in the first place to signal a problem developing you don’t get the luxury of time to investigate and work up a solution. That’s the value of being financially literate – knowing how to read the numbers.
Conclusion
Take responsibility for your business. Work with your accountant to produce, understand and take action on your critical financial ratios. Owners who take the trouble to understand the purpose of financial statements are far more likely to be making the right decisions about growing their business.
I don’t think it’s putting it too strongly to say that the owner who does not understand the essentials of their financial statements is surrendering their managerial responsibility. In my experience, owners who take the trouble to understand the purpose of financial statements, which is to say no more than to understand the essential information for how to direct and control their own business, are far more likely to be making the right decisions about growing their business.
You can leave it to your accountant or bookkeeper to take care of toting up the numbers and giving you the final results to be sent to IRD and then filing them away, while you focus on the exciting parts of your business. But having produced all the figures and then shelving them when they could be helping you manage the business is just irresponsible. Working with your accountant to produce, understand and take action on what the figures are showing regularly is a much better approach.
I hope I have given you the incentive to take that responsibility on board.