Keeping track of your business’s performance is one of the most important tasks you face as a business manager. Without sound information you cannot make good decisions, and it is therefore vital that you keep a close eye on the health of your company.
There are several key accounting ratios you can use to help you determine, amongst other things, how profitable your business is, as well as its performance in the most important areas. Don’t be put off by the apparently complicated name; these are actually relatively simple calculations that you can do on a regular basis with very little work. Indeed, if you set up a spreadsheet with the ratios built in, you can automatically generate the answers by simply typing in your monthly figures.
Is my business profitable?
Profit and loss statements are useful for determining whether or not your business is in profit, but they do not give a contextualised view of the health of your organisation. For example, they do not tell you whether your profits are growing at a suitable rate in comparison to the size of the business as a whole, or how well your business compares to others in its sector. Accounting ratios can help you do this.
The gross profit margin is potentially the most important accounting ratio available to business managers. It shows you how much gross profit you are making as a proportion of the total turnover of your business. Changes in your gross profit margin are a good indicator of changes in the general health of your business, and should lead to new management decisions. For example, if your gross profit margin goes down, you might consider renegotiating your deals with suppliers.
Gross profit margin is calculated like this:
Gross profit margin = gross profit / turnover x 100
This will produce a percentage figure. For example, if your gross profit was £40,000 and your total turnover was £160,000, your gross profit margin would be 25%.
You should also consider looking at the return on your assets - that is, your profits as a proportion of the value of your business’s assets. Your return on assets should increase over time as the initial investment involved in establishing a business is recouped. As such, this is a particularly useful ratio for judging the progress of a new venture.
Return on assets should perhaps best be described as return on capital; you are actually interested in the capital invested in your business - that is, the total assets minus the total liabilities.
So, return on assets (or return on capital) is calculated like this:
Return on assets = net profit / (total assets - total liabilities) x 100
Again, this will produce a percentage figure. For example, if your net profit was £50,000 and the capital invested in your business (that is, the value of your assets less the value of your liabilities) was £100,000, your return on assets would be 50%.
Is my business solvent?
Perhaps your most important concern is that of solvency. There are two key accounting ratios that will show you whether your business is technically solvent. These are the current ratio and the acid test ratio.
The current ratio looks at ‘current’ liabilities and assets; that is, those payable or receivable within the year respectively. The current ratio is calculated like this:
Current ratio = current assets Ã· current liabilities
So, if your current assets are £100,000 and your current liabilities are £50,000, your current ratio would be 2:1. A ratio of 1:1 is considered to be the marker of solvency, as this means you have enough assets to cover your liabilities.
The current ratio can, however, give a misleading view of the ‘real’ solvency of your business. You must remain effectively (as well as technically) solvent on a day-to-day basis, meaning that you must be able to pay your debts as they fall due. The acid test ratio gives a better view of your ability to do this, as it does not count stock as part of your assets. Stock can be difficult to translate into cash, and high stock levels as a proportion of your total assets can therefore give a misleading impression of the liquidity of your business.
The acid test ratio is calculated like this:
Acid test ratio = (current assets - stock) Ã· current liabilities
For example, if your current assets are £100,000 but £50,000 of this is stock, and your current liabilities are £50,000, your acid test ratio would be 1:1. As such, your business would be solvent but you would need to keep a close eye on your liabilities.
Is my business performing well in important areas?
There are a number of areas that you should keep particularly close track of, as they are good indicators of the stability of your business. These include your level of borrowing and the size of your overheads.
You should keep a particularly close eye on your borrowing ratio. This describes the amount of debt as a proportion of the total value of your business. You should, of course, have considerably more equity than debt in order to maintain stability.
The borrowing ratio is calculated like this:
Borrowing ratio = total borrowings Ã· net value of business
For example, if you had total borrowings of £100,000 and the net value of your business was £200,000, your borrowing ratio would be 1:2. This is considered healthy; it is normally suggested that the ratio should be at least 1:1.
You should also keep track of your overheads. Agile businesses with low overheads are frequently the most successful, and you should therefore make sure that you monitor any changes in the amount they are costing you. Comparing overheads to turnover is useful as it gives you a clear idea of whether or not your spending is in line with your income.
The overheads ratio is calculated like this:
Overheads ratio = overheads Ã· turnover x 100
While this figure does not give you much information on its own, it becomes very useful when monitored over time. It is generally expected that overheads should shrink over time. Any increase in your overheads ratio should be questioned.
Where can my business improve?
Finally, accounting ratios can be used to identify areas of improvement for your business. By monitoring a few key figures you can ascertain where you should focus your efforts.
One of the most useful accounting metrics for monitoring the efficiency of individual parts of your business is the collection period. This looks at the number of days for which invoices age before they are settled, and will give you a good idea of the efficiency of your debt management practices.
The collection period is calculated like this:
Collection period = debts owed Ã· turnover x 365
You should continue to monitor this ratio, and take pro-active steps to ensure that, at the very least, it does not get worse. You may also find our article on debt management techniques useful.
As you can see, key accounting ratios are not overly complex. Indeed, they can be efficiently used by every business manager to gain a deeper, more detailed understanding of the health of an organisation. Monitoring these ratios on a regular basis will help ensure that you maintain an accurate picture of the stability and well-being of your business.