Most people in business are great at what they do, but when you talk to them about financial figures, they run for the hills. There are ten basic numbers and ratios every business owner just needs to know – and luckily, they are easy and quick. Don’t worry, I’m not trying to make you an accountant, but I am trying to give you a basic understanding of the financial drivers of your business.
First, a caveat – Never look at financial numbers in isolation. They should either be compared to the industry benchmarks and/or analysed over time as a trend.
These are numbers, ratios and margins that tell us whether your company is making an adequate return. Adequate return is subjective – what is adequate to one person, one investor, one owner, one banker, or one industry?
Companies with a product or service that is easy to replicate or commoditise usually have low margins. Companies that have a competitive advantage or a barrier to entry usually have high margins. New products usually have a high margin to begin with, and as competition increases, the margin reduces.
1 Gross Profit Margin
This ratio tells us how much revenue is left over after paying for the product that generated the revenue.
Gross Profit Margin=Revenue less Cost of Goods SoldRevenue
In the example above 40% of the revenue is left over after paying for the product.
This number is important (and arguably the most important) because it will quickly tell us if there is sufficient revenue to cover the selling and administrative costs or overheads.
Increasing sales or revenues alone without understanding and managing the costs will create cash flow problems and make you unprofitable. Just looking at the Gross Profit Margin will quickly tell you if you are in a good position.
2 Operating Profit Margin
Operating Profit Margin tells us how much profit the business is generating after taking into account both the cost of goods sold and the operational and administrative expenses.
Operating Profit Margin=Gross Profit less Operating ExpensesRevenue
For sole trader businesses, I suggest excluding owners’ drawings, wages and expenses. For example, if you run a cafe excluding the owner-related expenses will give you a better picture, as if the cafe is generating enough revenue to cover its running or operating costs. If the owner decides to pay themselves too much and their costs are included in the operating costs, the picture the Operating Profit Margin paints will distort the reality.
Operating Profit Margin is often confused with the ratio below – Net Profit Margin.
3 Net Profit Margin
The Net Profit Margin shows the profitability of the business after accounting for all relevant costs. It also shows the return to the shareholder or owner.
Net Profit Margin=Net ProfitRevenue
This ratio should be analysed over time, and you are looking for a consistent and strong ratio. Deterioration over time may indicate a period of abnormal costs or conditions. It may also indicate cost blowouts.
The ratio should be compared to the industry and/or the shareholder or owner’s expectation of adequate return. A low margin compared to the industry indicates a margin squeeze and that productivity improvements or initiatives are needed. A shareholder or business owner should expect a return representative of the risk of the investment.
Activity ratios tell the business how efficiently they are using their short-term assets (especially cash) and indicate operational performance.
4 Working Capital (Current Ratio)
The working capital ratio can give an indication of the ability of your business to pay its bills.
A stronger ratio indicates a better ability to meet ongoing and unexpected bills, therefore taking the pressure off your cash flow. Being in a ‘liquid’ position can also have advantages such as being able to negotiate cash discounts with your suppliers.
A weaker ratio may indicate that your business is having greater difficulties meeting its short-term commitments and that additional working capital support is required. Having to pay bills before payments are received may be the issue in which case an overdraft could assist. Alternatively, building up a reserve of cash investments may create a sound working capital buffer.
Net working capital can also estimate the ability of a company to grow quickly. If it has substantial cash reserves, it may have enough cash to rapidly scale up the business. Conversely, a tight working capital situation makes it unlikely that a business has the financial means to speed up its rate of growth. A Working Capital Ratio greater than 2 is usually considered desirable; however, it is a matter of balance.
5 Debtor Days
Debtor Days indicate the average length of time it takes from when you make the sale to when you receive payment. This measures how quickly and efficiently a business collects its outstanding bills.
A larger number of debtor days means that a business must invest more cash in its unpaid accounts receivable asset, while a smaller number implies that there is a smaller investment in accounts receivable, and that therefore more cash is being made available for other uses.
Debtor Days should be looked at over time to see if there is a trend. A long Debtor Days may indicate that customers are struggling to pay their accounts, or lax credit monitoring. Economic factors such as a recession may lengthen Debtor Days and may require a tightening of credit control processes.
Lower Debtor Days numbers are generally better. However, a low Debtor Days compared to the industry benchmark may mean your credit terms are too stringent and that you are potentially missing out on sales opportunities.
It is a useful exercise to list your debtors and then order them by how outstanding they are. This is known as an Aged Debtor Report. This report divides the age of the accounts receivable into various buckets, which you can sometimes alter within the accounting software to match your billing terms. The most common time buckets are from 0-30 days old, 31-60 days old, 61-90 days old, and older than 90 days. Any invoices falling into the time buckets representing periods greater than 30 days are cause for an increasing sense of alarm, especially if they drop into the oldest time bucket. This report prioritises the debtors that need following up, and accounting software systems often will also provide the contact name, email address and phone number.
6 Creditor Days
Creditor Days indicate the average length of time it takes your business to pay its bills.
Again, this ratio needs to look at a trend and be compared to industry benchmarks. A declining ratio may indicate a worsening working capital position due to a decreasing stock turn or lengthening debtor days.
7 Inventory Days or Stock Turn
The Inventory Days or Stock Turn shows how many days it takes for the inventory to be sold and replaced.
For service-based businesses, replace Average Inventory with Average Work in Progress.
A low Inventory Days may indicate positive factors such as good stock demand and management. It also means fewer resources (usually cash) tied up in inventory. However, a too low Inventory Days may be a sign that the inventory levels are too low and unable to support an increase in demand.
A high Inventory Days may indicate that either stock is naturally slow moving or problems such as obsolete stock or good presentation. A high Inventory Days can also be indicative of potential stock valuation issues.
A caveat – Inventory Days is very industry specific. An industry where the inventory is not perishable or go out of date, it may be appropriate to have higher Inventory Days. Likewise, where the goods are imported, and it takes time to replace inventory, it may be appropriate to hold more inventory, such as cars.
Liquidity ratios measure the business’ ability to meet its short-term liabilities. They are especially important to banks and creditors when applying for loans or credit applications.
8 Current Ratio
Current Ratio is also known as Working Capital Ratio and is discussed above. It indicates if the business can pay off its short-term liabilities in an emergency by liquidating its current assets.
A high Current Ratio indicates a good level of liquidity but if the ratio is too high, it may indicate other problems. The inventory levels may be too high, valued incorrectly, or include too much obsolete inventory. There also may be a high debtor balance due to poor credit control or too generous payment terms.
9 Quick Asset Ratio
The Quick Asset Ratio gives a more conservative measure of liquidity than the Current Ratio. The Quick Asset Ratio excludes inventory as the value of the inventory that is realised in a ‘fire sale’ situation would be a lot less than the book value. It should also exclude any prepaid expenses.
In the example above, the quick Asset Ratio greater than 1 indicates that current liabilities can be met from the current assets without having to liquidate inventory.
10 Cash Ratio
The Cash Ratio is like the Quick Asset Ratio but excludes any other non-cash current assets such as Debtors. It is the most conservative liquidity ratio.