Key Accounting Ratios
You can monitor your business’s performance with tools called key accounting ratios, which help you to interpret financial information about your company. The more you know about how your business is performing, the easier it will be for you to make informed decisions about how to manage and grow your business.
The guide explains key ratios to help you address these vital issues:
- Is your business solvent?
- Is your business profitable?
- What is your return on assets?
- How is your business performing in key areas?
The records you keep can provide a great deal of information about your business and its performance. Details of sales made to customers, purchases made from suppliers and payments made to employees can all be used to see how the business is doing.
Just as importantly, the information can be used to compare the performance of the business with its previous track record and with the performance of other similar businesses. You can also make comparisons to review how profitable the business is, how efficiently it is performing, and whether it is able to pay its bills on time.
This guide shows you what to monitor and how to interpret key financial information about your company. Remember that with most of these measures, the trend over time is often more revealing than one figure in isolation.
Is your business solvent?
A business is considered to be solvent when it can pay its debts as they become due. In day-to-day terms, this means it can pay its suppliers by having enough working capital.
There are two key ratios that help us determine whether a business is showing a solvent position:
- Current ratio.
- Quick ratio (sometimes called acid test ratio).
The current ratio looks at the relationship between current assets and current liabilities. These figures are always shown on the balance sheet and the ratio is calculated as follows:
Current ratio = current assets ÷ current liabilities
Current assets include: stock, debtors and cash. Current liabilities include: trade creditors, current tax liabilities, bank overdraft and so on.
The word ”current” implies short-term assets or liabilities, payable or receivable within one year.
If current assets totalled £40,000 and current liabilities £20,000, then the current ratio would be:
Current ratio = £40,000 ÷ £20,000 = 2:1
This would be considered a healthy result showing you have enough current assets to pay current liabilities as soon as they are due.
Historically, a ratio below 2:1 would have given cause for concern about the ability of a business to meet its debts and trade successfully. Today, businesses tend to work within a ratio of 1:1.
The quick ratio, or acid test ratio, is useful as it measures liquidity more precisely than the current ratio.
This is because it does not include the value of stock within current assets. Turning stock into cash takes time, with payment terms typically standing at 30 days or more.
So you calculate the quick ratio by dividing current assets (without stock) by current liabilities:
Quick ratio = current assets less stock ÷ current liabilities
Using the figures from the example shown for the current ratio, and assuming the value of stock to be £10,000, we see the quick ratio would be:
Quick ratio = (£40,000 – £10,000) ÷ £20,000
= £30,000 ÷ £20,000
Historically, this would be considered a satisfactory result, but here too, businesses are tending to work with a lower ratio.
When reviewing the liquidity of a business, it is common practice to look at both the current ratio and quick ratio. For example, a business may look healthy using the current ratio, but this won’t show if it’s carrying too much stock.
An apparently healthy level of current assets might hide the fact that a large proportion of the current assets is made up of stock. Stock can usually be turned into cash – but only over time, and to do it quickly might require discounting.
Is your business profitable?
You can see if your business is profitable by preparing a profit and loss account, but you need to put that profit into perspective. Ask yourself:
- Is the profit growing in proportion to the size of the business?
- Is the profit growing or falling in relative terms – are you making as much profit on extra sales as you were on existing sales?
- Is the business as profitable as other businesses in the same sector?
The size of a business is often measured by looking at:
- Levels of turnover.
- Value of assets.
- Amount of capital invested in the business.
- Number of employees.
You can put the profit in perspective by looking at various ratios which compare profit as a percentage of sales or assets.
Gross profit margin
One of the most commonly used ratios is the gross profit margin, which looks at gross profit as a percentage of turnover:
Gross profit % = gross profit ÷ turnover x 100
So if a business makes a gross profit of £45,000 from sales of £135,000, the calculation will be:
Gross profit % = £45,000 ÷ £135,000 x 100 = 33%
This means that for every £1 of sales the business achieves, profit after taking off the costs of production is 33p.
Small changes in this percentage can indicate that your costs of production are creeping up, which should prompt you to consider increasing prices or looking for cheaper suppliers.
Your gross profit margin is not the same as your mark up, which is calculated as follows:
Mark up = gross profit ÷ cost of sales x100
So for the previous example, the mark up would be:
Mark up = 45,000 ÷ 90,000 x 100 = 50%
Calculating your breaking-even point
Your gross margin can also be used to calculate your break-even point, ie the level of sales you need to achieve to make a profit:
Break-even = fixed expenses ÷ gross margin
For example, for a business with fixed expenses of £50,000 and a gross margin of 40 per cent, break-even would be at £125,000 of sales.
Net profit margin
This ratio is similar to the gross profit margin but looks at net profit as a percentage of turnover.
Net profit % = net profit ÷ turnover x 100
For example, if the business makes net profits of £20,000 from a turnover of £100,000, the net profit percentage would be calculated like this:
Net profit % = £20,000 ÷ £100,000 x 100 = 20%
This ratio provides a good measure of performance, but if the percentage is declining, it is subject to many variable elements, making it difficult to correct.
The net profit is calculated after taking account of all costs and may be affected by a declining gross profit or by increased selling or administration costs within the business. If your net profit percentage is declining it is worth looking at your costs on an individual basis to see what you can do about those that have increased the most proportionally.
It is important to look at the trend which emerges over several accounting periods, as opposed to individual figures.
The ratios can be used to measure periods other than a full year, as long as you have the data to work out the figures.
What is your return on assets?
You can also measure the level of profit compared to the value of net assets invested in your business.
The assets are the major items that need to be in place to do business, including fixed assets (buildings, plant, vehicles, computers) and current assets (stock, debtors, cash).
The net asset total looks at total assets less liabilities. This represents the amount of capital invested in the business.
You can therefore look at the net profit as a percentage of capital employed.
The return that a business can expect differs by business sector and varies over time, depending on the economic cycle. However, it remains a good measure of business efficiency.
The ratio is calculated:
Return on assets = net profit ÷ net assets x 100
If the net profit was £20,000 as shown in the profit and loss account, and net assets were £200,000, then the return on assets would be:
Return on assets = £20,000 ÷ £200,000 x 100 = 10%
How is your business performing in key areas?
There are several ratios which you can use to measure how individual aspects of a business are performing.
You’ve already looked at the big measures – can you pay the bills as they fall due? Are you making the sort of profit at the gross or net level that you used to, or expected to? But by looking at individual parts of the business, you can gain more insight into profitability and efficiency.
These ratios include:
- Borrowing ratio.
- Average collection period.
- Creditor days.
- Stock turnover.
- Overheads as a percentage of turnover.
The borrowing ratio (gearing)
This ratio looks at total borrowings divided by net worth of the business. The idea is that the relationship between borrowings and equity should be in balance, with equity being significantly higher than debt.
For example, if your borrowings come to £30,000 and the business’s net worth (as shown in the balance sheet) is £90,000, then the borrowing ratio would be 1:3. This would be positive: usually bankers and financiers like to see this ratio at a level of at least 1:1.
Average collection period (debtor days)
This ratio is used widely within businesses to measure the effectiveness of a debt collection routine. It sets out the relationship between debtors and the sales that have been made on credit, and also shows how quickly customers are paying their invoices.
The calculation is:
Debtor days = debtors ÷ turnover x 365
This ratio gives a rather broad-brush calculation. A more detailed calculation would look at how many days’ turnover it took to make up the debtor total.
Current debtors – £50,000
Sales in current month (incl VAT) – £30,000
Sales in previous month (incl VAT) – £40,000
Debtors therefore represent all of the current month’s sales and half of the previous month’s sales.
If the current month includes 31 days, and the previous month was 30 days, total debtor days would appear:
Current month – 31 days
Balance from previous month: £20,000 ÷ £40,000 x 30 days – 15 days
Total debtor days – 46 days
If this ratio starts to increase, look carefully at your debtor collection routines.
Are your customers taking a long time to pay you? Is one of your customers building up a large debt? If the answer to either of these questions is yes, then you should probably take action sooner rather than later. Don’t forget, the older a debt becomes, the more likely it is to go bad.
Find out more about How to get paid on time and improve your cashflow
This ratio sets out the number of days taken to pay suppliers. This is less important than the debtor day statistic, as in this case the control over payment of suppliers is in your hands.
When assessing another business, for example one that is asking you for increased credit, this ratio can give a useful pointer as to whether the business is taking longer to pay people. Outside credit reference agencies use the calculations to give a profile of the business to potential suppliers looking for details about a business.
The ratio is calculated:
Creditor days = creditors ÷ purchases x 365
This ratio looks at how quickly you turn over stock into sales, and is another good measure of efficiency:
Stock turnover = cost of goods sold ÷ stock value
For example, if the cost of goods sold is £50,000, and the average stock held during the year is £10,000, then stock has been “turned over” five times during the year.
A quick turnover suggests that the business is efficient in holding the minimum stock used within the business.
Again, the trend over time is very important. If your stock turn is slowing, this may highlight a problem with slow-moving lines which may require discounting to sell through.
Overheads as a percentage of turnover
Again, reviewing overheads in relationship to turnover can be a useful tool in assessing whether they are growing more rapidly than they should.
The calculation is overheads ÷ turnover x 100
The calculation means little on its own, but when reviewed over several periods it can provide useful trend information.
As the business grows, this percentage should fall. If it doesn’t, then you need to review your overhead costs carefully to understand why this is happening and see what you can do to correct it. For example, if your telephone or utility costs are increasing, you may want to think about switching suppliers.
This business advice article published in association with Lloyds TSB.
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