As a small business owner, you will know about Profit & Loss Statements and Balance Sheets.
They tell you about your business profitability and net assets. You can see, from one period to another, whether you are making more profits than before, or less. They are the start to giving you information about the performance of your business, and hopefully leading you to create strategies to improve profitability and to increase wealth.
However, they have their limitations. For a start, they are historic. They give you the bigger picture, but unless you analyse them, they fail to break it down into the component parts.
Where is the profit coming from, or where is it not? How solvent are you and what's up ahead?
That's why it's important to dig deeper and put some attention to key financial ratios.
Financial ratios are the relationships between key numbers in your accounts.
Some financial ratios tell you about the profitability of your business. Others inform you about your liquidity, and yet others will tell you about the efficiency of your financial assets.
If you really want to understand how your business is performing, you need to pay attention to 8 financial ratios which are important to a small business. You can download a free Excel spreadsheet here to calculate your own key ratios. You can work out your own ratios and follow the below analysis.
The 8 financial ratios are:
- The Current Ratio (measures liquidity)
- The Quick Ratio (measures liquidity)
- The Sales Growth percentage (measures profitability)
- The Gross Profit Margin (measures profitability)
- The Net Profit Margin (measures profitability)
- The Return on Equity (measures profitability)
- The Accounts Receivable Days (measures business financial efficiency)
- The Inventory Turnover Days (measures business financial efficiency)
Let's go through them in turn.
Your Current Ratio is a measure of your liquidity. It compares your current assets to your current liabilities. "Current" assets are assets that will convert to cash within 12 months, and "current" liabilities are debts that you have to pay within 12 months.
Your current assets are all your cash and other assets that are convertible to cash within 12 months (usually including accounts receivable, inventory or stock or work in progress, and sundry loans you have made). Your current liabilities are all the liabilities you need to repay within 12 months, including any loan and lease repayments payable in 12 months.
Your Current Ratio is calculated by dividing your current assets by your current liabilities and reporting it as a figure compared to 1.
For example, say your current assets on 30 June was $100,000 and your current liabilities on that date were $85,000, then the ratio of your current assets to your current liabilities is 100,000/85,000 or $1.18 to $1
This means that you have $1.18 in current assets for every $1 of current liability.
Compare this to another period in the past, say the year before. Is it going up or down? If over time it is going up (say last year in the above example it had been 1.0:1 then your liquidity is getting better because a year ago you had $1 in current assets against $1 in current liabilities whereas this year you now have $1.18 in current assets to every $1 in current liabilities.
Depending on your industry, a ratio of anything less than 1:1 may mean you have a liquidity issue i.e. you have less than $1 of current assets to meet every $1 of current liability. However, even a ratio of 1:1 may already be an indication of liquidity issues because you may need a ratio of more than 1 to 1 since the current assets may include assets that take a long time to convert to cash - perhaps longer than the time you have to pay your current liabilities.
If your Current Ratio is trending down, or if it indicates you are losing liquidity, you need to consider what you can do in order to reverse the trend.
Can you get more long term capital or funding to lengthen the time when liabilities have to be paid? Can you sell some unwanted fixed assets like old equipment to add to cash? Should you reduce your salary and keep more assets in the business?
Your Quick Ratio is a measure of whether you could pay all your current liabilities quickly if you had to. It is an important liquidity measure.
It compares "quick" assets to current liabilities. Quick assets are cash or assets that can be converted to cash very quickly. For this reason, while accounts receivable are usually included as quick assets, inventory is not, because it is felt that you cannot normally convert inventory to cash quickly enough. Sometimes, what is included as a quick asset is a judgement call.
For example, you might include a temporary loan to an employee as a quick loan if you knew that they would repay you in the next few paydays, or you might not if you felt that they would not be able to pay you within the next few months.
The Quick Ratio is calculated by dividing the total "quick" assets by current liabilities.
In the above example, say of the $100,000 current assets, you judged that quick assets consisted of cash and receivables which total $90,000. Since the current liabilities were $85,000 the Quick Ratio is 90,000/85,000 or $1.06 to $1.
This means that you have $1.06 cash or nearly cash assets to pay every $1 in current liabilities if you had to pay all the current liabilities quickly.
Anything less than 1:1 is potentially a serious liquidity issue. You should again compare to past periods and evaluate the trend. You should also check with your industry standards to see what the average is for your industry. If the industry average is 2:1 and yours is 1:1 then why are you so different?
Again, if you decide your Quick Ratio is trending downwards or is performing poorly against your industry averages, look for strategies to change this. Perhaps you can sell old inventory in a sale, converting slow-moving stock to cash? Can you negotiate with creditors so that you extend payment periods into the long term?
Your Sales Growth
Your Sales Growth percentage is a measure of how your sales have grown (or declined) from one period to another. While not actually a measure of your profitability, it is an important secondary piece of information to help you analyse your profitability.
It is calculated by taking the increase (or decrease) in sales from one period to another and dividing it by the sales of the earlier period, and it is expressed as a percentage.
For example, if your sales this year was $500,000 and it was $400,000 last year, then it has increased by $100,000. Dividing 100,000 by 400,000 results in an increase in sales of 25% from last year.
Obviously, you would look for steady growth in sales from one period to another. However, a modest growth or even a decline may not be a bad thing in itself. You would need to compare this result with other factors such as Gross Profit Margin and Net Profit Margin (discussed below) because although sales may have slowed, you have become more profitable with lower sales by say, finding cheaper supplies.
You should also compare the result with your sales volumes. If you are selling more units of product but your sales are declining, then your pricing model needs to be looked at - you may be pricing too low compared to previous years. Remember to bear in mind how the economy is affecting you and your industry, as well as check to see if competitors are also experiencing the same trends.
If your sales growth is slowing, strategies include increasing profitability on the lower sales (lower cost of sales or lower overhead expenses) and increasing your marketing to find more customers.
Your Gross Profit Margin
Your Gross Profit Margin is the measure, in percentage terms, of how much profit you are making after direct costs (cost of goods sold) but before overheads and other expenses.
It is a measure of how profitable you are and it is calculated by dividing the Gross Profit by Sales and the result expressed as a percentage.
For example, if you had sales of $900,000 and your cost of goods sold or direct costs were $500,000, then your Gross Profit is $400,000 leftover to meet overheads and other expenses. In other words, you made $400,000 direct profits from the product before your overheads.
Expressed as a percentage, $400,000 divided by $900,000 is 44.44%
In this example, it means that for every $1 of sales, you are making $44.44 to meet your overheads and other expenses.
Your Gross Profit Margin is different from your Markup. Markup (or how you price to make a profit on your cost of goods) is calculated by adding a percentage on top of costs. So for example, if I said you had a Markup of 10% it means that you add 10% to your cost of goods to get your selling price. Say you buy a widget for $10 and your markup is 10%, then your selling price is $11. Your gross profit on the other hand is $11-$10=$1; $1/$11=9.09%
Again, look for trends - what was it in past periods. Why is it going up (or down)?
Also, compare it to your sales in this and past periods. If your sales are going up but your gross profit margin is going down, is that intentional? Are you reducing your prices and profits to get more sales volume? If it's not intentional, what's going on?
Compare with industry averages. Why are you different from the rest of your industry?
If your Gross Profit is reducing, you need to look at cost of goods sold and the efficiency of direct costs. Or, you need to look at increasing your prices to keep up with direct costs.
Your Net Profit Margin
Your Net Profit Margin is similar to your Gross Profit Margin except that it is calculated using your net profit after all overheads and expenses (but before tax). Your Net Profit Margin is another measure of your profitability.
So continuing the above example, say your gross profit of $400,000 calculated above is used to pay $300,000 in overheads and other expenses (but not tax), then your net profit is $100,000 before tax.
In this case, $100,000 net profit divided by $$900,000 sales gives you a Net Profit Margin of 11.11% or, for every $1 in sales, you make just over 11 cents after paying the cost of goods, overheads and other expenses.
It is possible (if you made a net loss) to have a negative percentage of Net Profit Margin.
Once again compare the result with past periods and industry averages and analyse why it is changing or different from the industry average. You may have to deep dive into the categories of products and eventually the amounts of overheads and expenses to understand why your Net Profit Margin may not be what is expected.
If your Net Profit as a percentage of sales is dropping, you need to look at any causes of a reduction in Gross Profit Margin (above) and then look at every expense item to see if it is increasing, and why. The solutions may be to buy cheaper, use less of the item, or increase prices.
Your Return On Equity
Your Return On Equity is the rate of return on what you have invested in your business. It is expressed as a percentage, and people have often referred it to as the "interest" you are earning from your business on your investment in it.
Think of it as if it were the return on a bank investment. If you invested $1,000 in a bank account and got $20 interest in a year, your rate of return on that investment is 2% per annum.
As a measure of your profitability, it actually measures how much you "get back" for leaving your investment in the business.
It is calculated by dividing your net profit before tax by your owners' equity/amount you invested.
What is owners' equity? It is basically your owners' funds - what you invested in the business, less any drawings or returns you pulled out, plus any profits you left in. In your accounts, this is usually shown clearly at the bottom of the balance sheet.
Let's say that your owners' equity was $500,000 and your net profit was $50,000 then your Return On Equity is 50,000/500,000 or 10%.
Once again the analysis lies in looking at trends. Is it going up or down compared to previous periods, and why? What is the expected return in your industry?
Sometimes, people also compare it to the bank interest rate.
In the example say the bank interest rate is 2% - for a relatively risk-free investment (the bank will always pay you out). So the question is, does the extra 8% you earn from leaving your money in the business the correct compensation for the risks of running the business (you may not always be paid out by your business!)?
If the rate of return is deemed to be too low, your strategies include all the "profitability" strategies above, to increase your profits and rate of profits. In extreme cases, it may help you decide if it is better to sell the business - in which you work so hard - to invest elsewhere for a better return and with less risk and hard work.
Your Accounts Receivables Days
This is a measure of your business' efficiency - that is, how quickly do you collect your debts.
This is important because you should not forget that making the sale is only half the equation - you have to collect the sale and put it in your bank!
Your Accounts Receivables Days are calculated by taking the average amount of accounts receivables (trade debtors) for the period you are measuring, and dividing it by the sales you made in that period, then multiplying by 365 to find the number of days.
Let's take this example:
- Say for the last year, your opening trade debtors was $20,000, and at the end of the year it was $30,000
- This means that the average trade debtors you carried during the year were (20,000+30,000)/2 or $25,000
- In that year your sales were $500,000 so, first divide the average by the sales, or 25,000/500,000 = 0.05
- Then, multiply the answer of 0.05 by 365 then you can say that it takes you an average of 18.25 days for you to collect your trade debtors.
Once again, comparisons with past periods will show you if you are getting better or worse at collecting debts, and comparison with industry averages can indicate what you might be doing wrong.
If the trend shows a decline, start to pay attention to older debtors. Put into place regular systems to chase the debts. Consider legal claims, and so on. You should also consider "sacking" poor performing customers - it doesn't matter how much they buy from you, if they don't pay you, the sale is a loss.
Your Inventory Turnover Days
Your Inventory Turnover Days is another measure of your efficiency, in this case about how quickly you turn over the inventory on your shelves.
Both this and the previous Accounts Receivables Days can also give you an indication of why you may be having liquidity problems. Obviously, if you are "inefficient" at collecting your debts, or your stocks sit on the shelves for too long, this means cash is tied up in debtors and inventory instead of sitting in the bank working for you.
Your Inventory Turnover Days is calculated in exactly the same way as the above Accounts Receivables Days, except that instead of calculating the average accounts receivables first, you calculate and then use the average inventory levels during the period you are calculating.
So for example, let's say that at the beginning of the year, your inventory was worth $20,000. At the end of the year after sales and restocking, it was worth $15,000.
Your average inventory level over the year was 20,000+15,000 divided by 2 or $17,500.
If your sales over that year were $500,000 then 17,500/500,000 results in 0.035.
Multiply 0.035 by 365 days in the year and your Inventory Turnover Days is just over 12.7 or, an item of stock stayed on your shelves for 12.7 days before it is sold.
The lower the number of days the better (quick moving stock). The higher the number of Inventory Turnover Days means the inventory sits on your shelves for too long and does not contribute to cash balances in that time.
Just as in the other ratios, the key is in comparing trends and industry averages.
If this ratio is deteriorating, look to change stock items to products that sell faster, or reduce the cost of stock purchases (fewer dollars stuck on shelves for long). Another strategy is to increase marketing so that all your product lines turn over quickly.
As you can see from the above discussion, calculating and then comparing some key ratios will tell you a lot more about how your business is performing in terms of liquidity, profitability and efficiency than a simple look over the dollars represented in the Profit and Loss account or the Balance Sheet.
If you make the comparisons to look at trends over time, and then ask yourself why those trends are being revealed, you can focus on the issues hiding behind the numbers.
You can download your free Excel worksheet here. Once you download, all you have to do is to fill in the cells highlighted in yellow, and your 8 key ratios will be calculated for you.
If you would like any assistance in interpreting your numbers, please contact us.