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- Have you got the funds to pay your bills when they’re due?
- Is your business profitable?
- Are you getting high enough returns from your business?
Although there are many financial ratios you can use to assess the health of the business, here are the main ones you can use easily. The ratios are grouped together under the key areas you should focus on. It is important not to get hung up on the calculations but just to understand what they're telling you as there are calculators to help you get the figures, such as the one below.
These ratios will assess your business's ability to pay its bills as they fall due. They indicate the ease of turning assets into cash. In general, it is better to have higher ratios in this category, that is, more current assets than current liabilities as an indication of sound business activities and an ability to withstand tight cash flow periods.
Current ratio = Total current assets
Total current liabilities
One of the most common measures of financial strength, this ratio measures whether the business has enough current assets to meet its due debts with a margin of safety. A generally acceptable current ratio is 2 to 1; however, this will depend on the nature of the industry and the form of its current assets and liabilities.
E.g. the business may have current assets made up predominantly of cash and would therefore survive with a relatively lower ratio.
Quick ratio = Current assets – stock on hand
Sometimes called the 'acid test ratio', this is one of the best measures of liquidity. By excluding stock which could take some time to turn into cash unless the price is 'knocked down', it concentrates on real, liquid assets. It helps answer the question: If the business does not receive income for a period, can it meet its current obligations with the readily convertible 'quick' funds on hand?
These ratios indicate the extent to which the business is able to meet all its debt obligations from sources other than cash flow. In essence, it answers the question: If the business suffers from reduced cash flow, will it be able to continue to meet the debt and interest expense obligations from other sources?
Commonly used solvency ratios are:
Leverage ratio = Total liabilities
The leverage (or gearing) ratio indicates the extent to which the business is reliant on debt financing versus equity to fund the assets of the business. Generally speaking, the higher the ratio, the more difficult it will be to obtain further borrowings.
Debt to assets = Total liabilities
This measures the percentage of assets being financed by liabilities. Generally speaking, this ratio should be less than 1, indicating adequacy of total assets to finance all debt.
These ratios will measure your business performance and ultimately indicate the level of success of your business operations. Comparing your net and gross margin calculations to those of other businesses within the same industry will provide you with comparative information and may highlight possible scope for improvement in your margins.
Gross margin ratio = Gross profit
This measures the percentage of sales dollars remaining (after obtaining or manufacturing the goods sold) available to pay the overhead expenses of the business.
Net margin ratio = Net profit
This measures the percentage of sales dollars left after all expenses (including stock), except income taxes. It provides a good opportunity to compare the business’s return on income with the performance of similar businesses.
Management ratios monitor how effectively you are managing your working capital, that is, how quickly you are replacing your stock, how often you are collecting debts outstanding from customers and how often you are paying your suppliers. These calculations provide an average that can be used to improve business performance. Comparing your management ratio calculations to those of other businesses within the same industry will provide you with comparative information that may highlight possible scope for improvement in your trading activities.
Stock days = Average Stock x 365
Cost of goods sold
This ratio reveals how well your stock is being managed. It is important because it will indicate how long you are holding your stock for. Usually, the less amount of time stock is held, the greater the profit.
Debtor days = Debtors x 365
This ratio indicates how well the cash from customers is being collected - referred to as accounts receivable. If accounts receivables are excessively slow in being converted to cash, the liquidity of your business will be severely affected. (Accounts receivable is the total outstanding amount owed to you by your customers.)
Creditor days = Creditors x 365
This ratio indicates how well accounts payable are being managed. If payables are being paid on average before agreed payment terms and/or before debts are being collected, cash flow will be impacted. If payments to suppliers are excessively slow, there is a possibility that the supplier relationships will be damaged.
Balance sheet ratios
These ratios will provide an indication of how effective your investment in the business is. The return on assets and investment ratios assess the efficiency of your business resources.
Return on assets = Net profit before tax x 100
This measures how efficiently profits are being generated from the assets employed in the business. The ratio will only have meaning when compared with the ratios of others in similar organisations. A low ratio in comparison with industry averages indicates an inefficient use of business assets.
Return on investment = Net profit before tax x 100
The return on investments (ROI) is perhaps the most important ratio of all as it tells you whether or not all the effort put into the business is,in addition to achieving the strategic objective, returning an appropriate return on the equity generated.