Understanding Financial Ratios

Understanding Financial Ratios

As part of our series in managing cash flow in your business, let’s talk about understanding financial ratios. They are an indicator in your business to give you the heads up on addressing current issues or trends, to ensure that you only get that burst of adrenaline from exhilaration, rather than shock!

Financial ratios are a useful management tool for monitoring the performance of a business and identifying potential problem areas. We’re going to take a look at some of the more commonly used ones, so that managing the highs and lows of your business becomes a way of operating and not an extreme sport.

Working capital or liquidity ration =      current assets /  current liabilities

This is a measure of whether your business can meet its short-term commitments (like bills) from its short term assets (like cash in the bank).  It is a measure of the adequacy of working capital.  If the ratio is greater than 1, then the business should be able to meet its debts when they fall due.   Ratio of less than 1 may indicate you’ll have a problem paying your bills. You don’t want to become insolvent as a result of your cash flow issues, so you should examine what’s coming in and out carefully, in this scenario. You need to work through a plan to be able to pay. The next ratio may help.

Debtors turnover =      Debtors x 365 days /  Sales

This represents the average days that it takes to collect debtors.  It is an indicator of your debt collection practices being within your terms and conditions of trading. For example, if your payment terms are within seven days, are you actually being paid within this time frame? An increase in the number of days may flag cash flow difficulties and you should address this immediately.

Gross profit ratio =        Gross profit  /  Sales

Gross profit expressed as a percentage of sales is an important benchmark for looking at the performance of your business. It can be used as a measure of how a business is performing, compared to previous years and other businesses within the same industry.  Industry averages can be obtained from sources such as The Australian Bureau of Statistics and your industry association.

Stock turnover =              Cost of Sales  /  Stock

This ratio indicates how many times a year stock is turned over. A low number may suggest that there are inefficiencies in stock control procedures and that you may either by carrying too much stock or a high proportion of slow moving or obsolete stock. It also may indicate that you need to address your sales and marketing to ensure stock sells.

Debt to equity ratio =         Liabilities /  Shareholder funds

The higher the debt to equity ratio, the higher is the level of interest that you are paying.  It may be an indicator as to whether you have over extended your borrowings.

Return on equity =           Net earning before tax  /  Equity

This represents the rate of return on your equity (as the business owner).  It is used as a comparative ratio for owners to determine whether they are obtaining a competitive return on their investment from their business.

To help get a handle on your business operations, a good place to start is better cash flow management. We’ll help you set up the right payment terms and conditions, and operations to ensure that you have the cash coming in to cover the cash going out (and more!). Every new bill shouldn’t give you an adrenaline response. Get in touch to book a free consultation to get your cash flow under control.