If all you’re doing is keeping track of your transactions, you could be missing key information about your businesses’ financial health. To measure your success and plan for the unexpected, take some time to consider these financial ratios next time you review your financial statements.
Management thinker Peter Drucker is quoted as saying that “you can’t manage what you can’t measure”, and your financial ratios are a great way to understand and measure your company’s performance.
By comparing two or more components from your financial statement, preferably over several periods, you’ll not only identify your wins but also any signs of trouble brewing.
The overarching benefit of calculating your ratios is that they’ll provide more insight than your standard reports offer on their own.
Ratios for monthly monitoring
To calculate your ratios you’ll need your financial statements, including your balance sheet, cash flow and income statement.
Working capital or current ratio
What it measures: How easily you’re able to pay short-term liability with your current assets.
Why it’s important: For creditors to determine how much of a risk your business is as a borrower, as well as for investors to understand your liquidity, how easily you can cover debts, and how quickly your business will be profitable.
How to calculate it: Divide your current assets by your current liabilities (current assets/current liabilities). The figures you need to do this are on your balance sheet.
What it means: If your ratio is too low, it means you have more liabilities than assets. If the ratio’s too high, you have money sitting in the bank that could be better used to grow your business. A good working capital ratio is generally considered to be between 1.2 and 2.
Example: You own a food truck. Your current asset (inventory) is R100 000 and your liability (what you owe creditors) is R85 000. To work out your ratio, you divide R100 000 by 85 000 to get 1.18.
Gross profit margin
What it measures: How much profit you have after you’ve paid for the cost of goods (COGS) sold. COGS are your direct costs that go into making your product or offering your service.
Why it’s important: It measures your company’s profitability.
How to calculate it: Divide your net sales (revenue) by your net sales minus COGS and multiply that by 100 to get your gross profit percentage (revenue/(revenue-COGS)x100). Start by working out your cost of goods sold. You’ll find the figures you need on your income statement.
What it means: Gross profit margins are important for measuring how efficiently you’re making money from your products and services because they measure profit as a percentage of your sales revenue.
Example: You have a garden service business. Your net sales are R200 00 a month, and your direct cost to carry out your service is R145 000. To calculate your gross profit margin: (200 000-145 000)/ 200 000 = 55 000/200 000 = 0.28. Multiplying this by 100 to get your percentage of 28%.
Inventory turnover ratio
What it measures: If you sell products, this ratio shows the rate at which you sell your inventory.
Why it’s important: This ratio will flag products that aren’t selling well and will help you decide whether to grow more popular lines. It also helps you compare seasonal or periodic changes.
How to calculate it: To calculate your inventory turnover, divide your COGS by your average inventory (COGS/average inventory).
What it means: The higher your inventory turnover ratio is the higher your sales volume, which is generally good.
Example: For the last financial year, the COGS for your plumbing business were R200 000. Your average inventory is R5 000. To find your inventory turnover ratio, divide R200 000 by R5 000 (200 000/5000). Your ratio is 4.0.
Trends and comparisons
Analysing your businesses’ ratios helps you to identify trends, compare performance – in your own business and with others in your sector – and gives lenders or investors the insight they need about your company’s financial well-being.
While there are many variations, for these simple calculations all you’ll need is your financial statement and balance sheet. However, interpreting your results may be more difficult if you have a limited understanding of bookkeeping or accounting processes.
Can we help you better understand your numbers? Give us a call today to book a free consultation.