Financial ratio analysis is a helpful tool that can be used to predict the success and measure the progress of your business, as well as spot warning signs. By spending time on financial ratio analysis, you will be able to identify trends in your business and use the results to improve overall performance.
Although there are numerous financial ratios you can use to assess the health of the business, here are few important ones you can use easily. The ratios are grouped together under the key areas you should focus on.
Liquidity ratios assess if your business has adequate cash to pay debts as they fall due.
- Current Ratio is one of the most common measures of financial strength.
Current Ratio = Total Current Assets / Total Current Liabilities
This ratio measures whether the business has enough current assets to meet its due debts with some margin of safety. A current ratio of 2:1 is generally acceptable; however, it will depend on the nature of the industry and the form of its current assets and liabilities.
- Quick Ratio is one of the best measures of liquidity.
Quick Ratio = (Total Current Assets — Value of Stock on Hand) / Total Current Liabilities
This ratio measures real, liquid assets by excluding the value of stock. It helps determine if a business can meet its current obligations with funds that can be readily converted to cash even if it doesn’t receive income for a period of time.
Profitability ratios measure your business performance and the success of your business activities.
- Gross Margin calculation measures the percentage of sales dollars remaining (after obtaining or manufacturing the goods sold) available to pay the overhead expenses of the business.Gross Margin = Net Sales (after sales commission and discounts) / Cost of Goods sold
- The Net Margin measures the percentage of sales dollars left after all expenses (including stock), except income taxes. It is a good ratio for comparing your business’s return on income with the performance of similar businesses.Net Margin = Net Profit / Net Sales
Management ratios monitor how quickly you are replacing your stock and how often you are collecting debts outstanding from customers. These calculations provide an average that can be used to improve business performance.
- Stock Turnover shows you how many times you replace your stock during a time frame. It divides the cost of goods sold by average stock value.
Stock Turnover Ratio = Cost of Goods Sold / ((Opening stock + closing stock) x 0.5)
This ratio is important because it indicates how quickly stock is being replaced. Usually, the more times inventory can be turned in a given operating cycle, the greater the profit.
- Debtor Days show you the average number of days it takes to collect cash from your customers.
Annual Debtor Days = (Debtors / Net Sales) x 365
If payments from debtors are slow in being converted to cash, the cash flow in your business will be severely affected. Ideally you want your debtor’s days to be as low as possible.
There are many more financial ratios you can use to measure the performance of your business. Don’t get too hung up on the calculations — there are a lot of calculators on the web you can use, and your online accounting software may also do this for you. What is more important is that you analyse the results and take action when needed.