Financial ratios are a key aspect of business performance measurement. What are the key ratios you should be watching in a fast growing business?
Ratios are of little use unless you compare them to targets, or to last year’s figures to identify trends, or compare to industry averages and benchmarks. Have you ever looked at your accounts and management reports, and wondered what some of the key ratios mean and how to improve them?
Also an important question that we often discuss with clients, is what are the key ratios you should be watching in a fast growing business?
There are three main classes of ratios: Profitability, Liquidity and Risk.
Below are some examples of key ratios:
1. Gross Profit margin = Gross profit/Revenue x 100%
Gross Profit is a critical measure of business performance. The higher the gross profit percentage, the more advantageous to a business – an obvious statement, but more true than you might realise. It measures the ability of the business to sell goods for more than they cost to make, and really determines how good the business is. It allows business owners to make critical decisions (e.g. whether to expand into a market, whether to take a customer on, what payment terms to offer). To increase your gross profit percentage, you could increase your selling prices, change and negotiate with suppliers (possibly bulk buying at a discount) but care is needed not to compromise quality. Then it comes down to the quality of the product and the strategic actions you are taking to ensure you are in a profitable space in your market. All in all, your Gross Profit is really the level of how sustainable the business is, and the power of Gross Profit should not be under-estimated.
2. True Net Profit (Retained profit) = True Net Profit (after owners actual remuneration/drawings, tax, donations etc.) / Sales
At the end of it all, your true net profit/retained profit is after everything has been thrown at it– tax, actual owners drawings, donations etc., and is the true amount of net profit that’s left in the business. This is vital to watch in a growing business, as it is this true net profit figure that gives you the profits to fund the growth in working capital that is required. Whether you like it or not, growth in working capital requirements (i.e. stock, trade debtors, trade creditors) will happen when you increase the size of the business, and it is critical to retain a decent true net profit to fund this. What is the right amount to retain? Our recommendation is at least 6-8% (of sales) minimum to retain as true net profit.
1. Receivable / Debtor collection days = Trade receivables [Trade Debtors]/revenue x 365 days
This is the average period it takes for a company’s debtors to pay what they owe. To be able to reduce the receivable days, make sure you have excellent credit control in place by invoicing on time and chasing up on bad debts. Make sure you frequently review your receivable summaries/aged debtor listings in detail on your accounting software and especially focus on any showing in the ‘older’ columns.
2. Liquidity (or Acid test) ratio = Current Assets minus Stock / Current Liabilities
This is a measure of how well a business can meet its short-term debts, and assuming the worst was to happen and you couldn't sell any of your stock (e.g. damage/fire etc.) . A ratio in excess of 1 is essential. The expected ratio varies according to the type of industry, but we would always recommend that you need to really achieve a ratio of at least 1.5 to be a safe sustainable business.
1. Gearing = (Total debt / Equity) x 100%
A high level of gearing indicates that the company relies heavily on debt to finance its long-term needs. The ratio can be improved by reducing the amount of debt and retaining profits and equity in the business.
Monitoring financial ratios in any business is essential, and especially one that is growing. It is like the instrument panel when flying a plane - the ratios are all telling you something as a business owner, and you need to know which ones to look at, and which ones to address urgently. Keeping an eye on the ratios, and knowing whether something is going astray or needs action, is something that your accountant and adviser should be able to help you with on a regular basis.