Interesting financial ratios worth knowing

It is worth knowing the important financial ratios in your business, because, to be successful, a business must make money. It must make enough net profit to:

• Repay its debts, on time;
• Re-invest in more growth;
• Sustain operations, and
• Pay the owners enough to live their desired lifestyle.

Understanding how a business makes money is different from just recording your financial transactions or reading the financial statements or management accounts prepared by your accountant as you would miss essential information.

What are financial ratios?

Financial ratios analyse your financial reports, either your monthly management accounts or annual financial statements that can reveal financial performance weaknesses and strengths beyond that of what financial statements and management accounts alone can bring to light.

There are literally loads of financial ratios that businesses can track, however, we’ll only be looking at those ratios that are well worth businesses knowing.

Why look at financial ratios for smaller businesses?

The term “financial ratios” can raise some uneasiness, even a tinge of trepidation amongst many business owners, believing it can be complex, frustrating to understand, excessive and an overkill for a small business, but that is not the case.

Having a good accountant to prepare the ratios and explain it to you will go a long way in appeasing those unhelpful assumptions and bring about a newly found enthusiasm as you begin to focus on the key elements that drive a business to become and stay profitable for the long haul.

Financial ratios go beyond the balance sheet and income statement, which are helpful, but limited in insight as to how efficient your business is at financing itself, making a net profit, managing cash flows, and growing the wealth of the business.  Ratios also provide a warning sign before there is an indication that things are not going well, letting you know in advance what changes need to be made.

Liquidity

In a nutshell, liquidity is the measurement of a business’s working capital that will provide either a positive or negative result.  In other words, liquidity is the ability of a business to pay its short-term debts (current liabilities) when they become due, for example, suppliers, VAT, employees’ taxes and other accounts payable using its short-term assets (current assets), for example, cash and customer amounts due.  When a business is having trouble paying employees, suppliers and covering other ordinary operating expenses, many business owners are under the incorrect assumption that this is a cash flow problem, but it is not, it is more serious than a cash flow issue, the business has liquidity difficulties, and that leads to bigger problems.

There are three worthwhile liquidity ratios to know:

#1 Current ratio (also known as working capital ratio)

The current ratio determines whether your business can pay its short-term debts with its current assets.

Ideally, the ratio should be between the 1,5 : 1 to 3,0 : 1 range. (that is between, 1,5 to 3).

If the current ratio of a business is higher than 1, this means that the business has positive working capital (its current assets are higher than its current liabilities).

#2 Acid Test ratio (also known as Quick ratio)

Another liquidity test is the acid test ratio which is similar to the current ratio in that it also determines whether the business can pay its debts when they become due, and is used far more commonly than the current ratio.

The reason why this ratio is more frequently used is that it looks at current assets that can be converted to cash quickly to pay debt, for example, cash and debtors (amounts owing by customers).

The formula for the quick ratio excludes inventory and prepaid expenses from the current assets because it can take time to sell inventory and turn it into cash and prepaid expenses cannot be converted into cash as the cash has already been expended.

If the ratio is higher than 1, this means that the business is in a good financial position. 

#3 Cash flow

Cash flow is not the same as liquidity and neither is cash flow a ratio or percentage ratio. However, it is important to understand the difference between the two.  Generally, liquidity is the ability of the business to pay its current debts (liabilities) using its current assets.  Cash flow on the other hand, refers to cash going into and out of the business’s bank account.  Cash flow is the timing difference in the sales cycle – it is the difference between when cash is paid to suppliers for goods or services and the timing difference between when those goods and services are sold and cash is received by the customer.

How a business manages liquidity and cash flow can impact on its short-term operations and ultimately, its survival.

The reasons for a business’s positive or negative cash flow are determined, amongst calculating other ratios, in a cash flow statement. The cash flow statement provides information on where funds were received from and where funds were expended on.

The cash flow statement takes the opening bank balance at the beginning of the month less the closing bank balance at the end of the month and simply analyses the movement of cash in and out of the bank for that month, for example, purchase of fixed assets, increase in inventory (outflow of cash), decrease in supplier (outflow of cash) and increase in debtors (more customers owning the business money = outflow of cash).

Working capital margin

The working capital margin calculates the percentage of working capital (net current assets) that the business is invested in to generate each rand of sales.

Net current assets = (current assets – current liabilities) – also known as working capital.

For example, if sales are R 180 000 and the average inventory and accounts receivable is R26 250 and the average accounts payable to suppliers is R18 000, the percentage of sales that has not been realised as cash is 4,6%

(R26 250 current assets – R18 000 current liabilities)/R180 000 sales x 100

Working capital margin = 4.6%

This means that for R180 000 of sales, 4.6% of those sales are invested in working capital. The lower the working capital margin is the less need the business has for having to obtain financing as they make efficient use of working capital.

Profitability

Liquidity and profitability are not the same thing. Profitability ratios assess a business’s ability to earn profits from its sales and operations or shareholders equity. It measures the business’s ability to convert sales into profits so that it can generate funds to reinvest or replace capital equipment, repay its long-term debts, for example, financing of machinery,  and invest in growth of the business.

#1 Gross profit percentage

As a business can likely sell products or services with varying gross profit margins, this is the most important ratio percentage to determine how much on average it costs to sell a product or deliver a service so that there is enough profit to cover overheads and repay long-term debt.

Gross profit is expressed as a ratio percentage and measures all products and services (cost of sales) as a percentage of sales.  Gross profit is the profit after subtracting the cost of goods or services from sales, but excludes expenses, such as rent, telephones and so on.  In a service industry, the cost of services are the salaries and wages and employee benefits paid to employees that directly generate sales, so this would not include a receptionist for instance.

(R250 000 sales – R170 000 cost of sales = R80 000 gross profit /sales R250000 x 100)

Gross profit percentage = 32%

#2 Break-even turnover

Break-even turnover is the minimum sales that a business must reach to pay for its overheads (expenses, including the owner’s salary).  It is a sales level that the business will neither make a net profit or a net loss.  Importantly, although this level of sales will cover expenses, it falls short of the level it needs to repay its long-term liabilities.

(R70 000 expenses / 32% gross profit percentage)

Break-even turnover = R218 750

#3 Profitability ratio

This is an important ratio because a business needs profits to reinvest in capital equipment, to repay long-term debt and to fund future growth.  A return on sales that is less than South Africa’s CPI index is a concern because reinvesting in capital equipment, financing rates and funding growth are all linked to inflation. Ultimately, business usually needs at least 5% above the CPI index.

This percentage ratio calculates the net profit before tax as a percentage of sales.  The higher this value, the better. An increasing value indicates better control of maintaining gross profit margins and percentage, and a decreasing value indicates too low selling prices or worse control of costs.

Net profit = (profit after deducting cost of sales and expenses from sales) expressed as a percentage over sales.

(R250 000 sales – R170 000 cost of sales – R70 000 expenses = R10 000 net profit / sales x 100)

Profitability ratio percentage = 4%

How BAN can help

Most small business owners blame their problems on “poor cash flow”.  If one understands the ratios above, one can easily determine that the reason is very seldom a problem with cash flow, but rather bigger problems elsewhere in the business.

These are just a few of the key financial ratios that are essential to quickly evaluate your business, as by tracking this over time through management account reports, a Business Accounting Network accountant can notice risks before they become a big problem and advise what needs to be done to improve your business’s performance and bottom line.

Ask your BAN accountant to prepare financial ratios to truly analyse the health of your business that will help identify gains and problems before they spiral out of control.