Our physical health is important to all of us, and we should always be diligent to look out for any early warning signs. If we suffer symptoms, we should consult a doctor and if the diagnosis is problematic, a solution should be prescribed and implemented.
In the same way, a business owner needs to be on the lookout for financial problems in the business. The sooner these problems are detected, the more likely a solution can be found and the problems resolved.
The indicators of financial problems are found in the numbers, which in accounting terms, are called “financial ratios.”
If you’ve ever been in the cockpit of a plane, you would have marvelled at all the gauges in front of the pilot. Every one of them tells the pilot whether the plane is operating properly and on-track. In a similar way, there are certain financial ratios that help a business owner know whether the business is operating properly and on-track.
These financial ratios will help the business owner see where potential problems might lie, what’s going well in the business, and how the business compares to similar businesses. When it comes to selling the business, the better the ratios, the higher the asking price (and vice versa).
Ratios can help answer the following questions:
- How profitable is the business?
- How efficiently is the business generating sales, compared to control costs?
- How much cash (liquidity) is available to run the business?
- How much capital risk (leverage) is the business exposed to?
Here are six important financial ratios that relate to most small businesses:
1. Gross Profit MarginThis ratio measures how profitable a business sells its products and services for. In other words, the gross profit ratio, is essentially the percentage mark-up on products and services from its cost.
The Gross Profit Margin is calculated as follows:
If you have detailed financial reporting, it is beneficial to get this ratio across all product lines.
2. Stock Turn
This ratio measures how many days it takes a business to sell its stock. It is expensive for a business to tie up capital in too much stock or obsolete stock that doesn’t sell. Stock can’t make money for the business if it is stuck on the shelves or in the warehouse. This ratio is calculated as follows:
3. Debtor Days
This ratio measures how many days it takes the business to collect its receivable payments. The higher the number of days, the more likely the business is experiencing cash flow problems.
Historically, many businesses have had this ratio at around 60 -70 days, when they have had their terms of trade as 20th of the month following invoice date.
With today’s modern practice, by updating your terms of trade from 20th of the month following, to 7 or 14 days after invoice date, and with the use of an external credit controller, I have seen this reduced to as much as 30 days or less, outstanding. This has a major beneficial impact on the cash flow of the business.
It is calculated as follows:
4. Creditors Days
This ratio measures how many days it takes the business to pay its bills. The higher the number of days, the more likely the business is experiencing cash flow problems, unless of course the business has negotiated excellent credit terms with its suppliers. It is calculated as follows:
Remember, if you are continually paying your creditors late, they will typically reflect this in the prices of the goods they charge you, i.e. they will put their prices up.
5. Interest Coverage
This ratio measures how easily a business can pay its interest expenses, on outstanding debt. Ideally, it should be over 1.5, but if it falls under 1, the business is probably not producing enough cash flow to pay interest. It is calculated as follows:
6. Current Ratio
This ratio measures a business’s ability to pay its short-term debts from its cash reserves, (or assets that can be quickly turned into cash). If it is less than 1, the business might have a cash flow problem. If it is a lot more than 1, the business might have too much cash that could be used elsewhere, or it is carrying too much stock. It is calculated as follows:
It takes skill to calculate and interpret these numbers, so it is important to either learn these skills or engage an experienced business advisor and/or chartered accountant, to help you with it. I suggest you do both.
How did you find the article? This is a chapter from my book: Starting a Business, Growing a Business. The Critical Insights No One Tells You About, But Should. If you are in business, you know how challenging it can be at times. If you’ve thought about running your own business, you’ve probably heard the odds are against you being successful. But all is not lost… Get your copy of my book where you will learn more tips to keep you on the path to success!
If you want help identifying problems in your cash flow and formulating solutions to resolve them or maybe you need an accountant in Auckland to do the work for you? You can check out our Cash Flow Management Coaching or simply book a call so we can discuss the specific needs of your business and how to best approach it.