The best way to the performance of your business is to use some key accounting ratios. These help you to analyse financial information about your business. Having this knowledge will aid making informed decisions about how to manage your business and help it to grow. This article highlights some of the common ratios that a business should use to measure its performance.
There are many factors to consider when looking at how profitable a business is. The profit and loss account shows the exact level; however, it is important to consider:
- Is profit increasing or decreasing in relative terms i.e. are you making as much profit on extra sales as you were on existing sales?
- Is profit comparable to other businesses in the same sector?
There are a variety of ratios that can be used to measure profit:
Gross profit percentage (margin)
Probably the most commonly used ratio is that of gross profit. This is gross profit as a percentage of turnover.
Gross profit % = gross profit / turnover x 100 So if a business makes a gross profit of £20k from sales of £50k, the calculation will be:
Gross profit % = £20k / £50k x 100 = 40%
This is often a measure used by HMRC to compare industry averages. Small changes can indicate issues within the business, costs could be increasing and therefore sales prices should be increased accordingly.
This is the level of sales that the business needS to achieve in order to make a profit:
Break even = fixed expenses / gross margin
Net profit margin
This ratio is similar to the gross profit margin but looks at net profit as a percentage of turnover.
Net profit % = net profit / turnover x 100
This ratio can provides a reasonable measure of performance; however it is generally subject to more variable elements. This therefore makes it difficult to compare and correct. The net profit is calculated after taking account of all costs. It is advisable to be reviewing these costs on an individual basis and identify where potential overspends are and savings can be made.
Return on Capital
This ratio measures the level of profit in relation to the net assets invested within the business. Net assets are shown on the balance sheet and is calculated as total assets less liabilities. This represents the amount of capital that has been invested in the business.
The ratio is calculated as: Return on assets = net profit / net assets x 100
Solvency and liquidity ratios
A business is considered to be solvent when it can pay its debts as they become due. In day-to-day terms, this means it can pay its suppliers by having enough working capital. There are two key ratios that help us determine whether a business is showing a solvent position:
Current/ quick ratio
This ratio looks at the relationship between current assets and current liabilities. These figures are on the balance sheet. The ratio is calculated as follows: Current ratio = current assets ÷ current liabilities Current assets will generally consist of stock, debtors and cash. Current liabilities can include: trade creditors, current tax liabilities, bank overdrafts. Where current assets are £20k and current liabilities £10k, then the ratio would be: Current ratio = £20k / £10k = 2:1 This means the business has enough current assets to pay current liabilities as soon as they are due.
This is also known as the acid test ratio and measures liquidity in a more effective way than the current ratio, as it removes the value of stock from within current assets. Converting stock to cash can take time. When reviewing liquidity, it is normal to look at both the current and quick ratios. A good level of current assets could hide the fact that a large proportion of the current assets is made up of stock.
There are some additional ratios which monitor the actual performance and efficiency of the business.
This ratio is used to measure how effective debt collection is within the business. It identifies the relationship between trade debtors and credit sales. Most importantly it tells you how quickly customers are paying up. The calculation is:
Debtor days = debtors / turnover x 365
This sets out the number of days taken to pay suppliers. It tends to be more useful when you are looking at taking on a customer as it will give an idea on their speed of payment. The ratio is calculated:
Creditor days = creditors ÷ purchases x 365
This ratio looks at how quickly you can convert stock held into sales: Stock turnover = cost of goods sold / stock value A quick turnover of stock will indicate the business is efficient and holding the minimum amount of stock to be used within the business.
These are standard ratios used across most industries. Each business should consider these as well as other tailored Key Performance Indicators (KPI’s). Measuring these against industry averages, previous years and competitors can quickly identify problems and issues within the business. Good management accounts should be prepared on a regular basis and these factors taken into account.