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Tracking your Business’ Performance with Ratios

If you run a business, here are some of the most important ratios you should be looking to monitor. They range from profitability, to liquidity, to efficiency and will, if monitored on a regular, periodic basis, give you good insight in to your business’ financial performance, enabling you to improve.

Current Ratio
Current Assets / Current Liabilities (expressed as a ratio e.g. 1.5:1)
This ratio gives you an indication of the ability to pay off liabilities within the current fiscal year with the assets you have available to you within the current fiscal year, which may include cash in the bank, inventory and other items that can be sold within the period to generate cash, to pay liabilities, within the period. The ratio can be communicated as; for every £1 liability, the company has £1.50 worth of capital that can be produced within the fiscal year to pay off liabilities. A ratio of 1:1 is required at minimum.

Quick Asset Ratio or Acid Test Ratio
(Current Assets – Stock) / Current Liabilities (expressed as a ratio e.g. 1.4:1)
This ratio gives you an indication of the business’ ability to pay off immediate liabilities with cash that is immediately available to the business i.e. Cash in the bank; this is why the calculation excludes stock because it assumes that there will be a time delay with selling stock. The ratio can be communicated as; for every £1 liability payable immediately, the company has £1.40 worth of capital available. A ratio of 1:1 is required at minimum.

Return on Capital Employed
(PBIT / (Total Assets – Current Liabilities) x 100
One of the most important profitability ratios; this measure will give you an indication of how worthwhile a project is based on it’s income relative to its investment. PBIT (Profit before Interest and Tax) is used so that we can directly compare ROCE’s with different projects, businesses etc, before they employ any tax and interest strategies. Non-current liabilities are not included in the calculation, as these may be interest payments for long-term loans or similar, where the loan may be used to generate income, that go beyond the project term.

Gross Profit Margin
(Gross Profit / Sales) x 100
This is a measure of how efficiently the business uses its resources labour and materials in the production process to generate its first layer of profit (cost of goods sold). The higher this figure the better. The figure gives a good indication of the profitability of operations before any costs of overheads are applied and is widely used in the investment community to determine potential opportunity e.g. a low margin may suggest the company is using its labour and materials inefficiently and therefore could be improved, resulting in increased profitability.

Operating Profit Margin
(Operating Profit / Sales) x 100
This is a measure of the business’ profitability after fixed costs overheads are applied to the calculation and gives an indication of the profit margin before interest and tax. Operating profit is also known as PBIT (Profit before interest and tax) and is another figure that is typically used to compare projects with to understand how efficiently businesses use resources, inclusive of their overheads.

Net Profit Margin
(Net Profit / Sales) x 100
This measure gives an indication to the margin the company achieves after variable costs, fixed costs, interest and tax. It is also another profitability measure that can be used to compare with other projects and businesses, but should be taken with a pinch of salt, as different companies can sometimes employ very different interest and tax strategies, convoluting the points of comparison; that’s why the PBIT/Operating Profit is the favoured ratio used when comparing projects and businesses.

Gearing or Leverage
(Long Term Liabilities / Capital Employed) x 100
The gearing ratio gives us an indication of the debt-to-equity structure of the business i.e. the proportion of finance that is provided by debt relative to the finance provided by equity (or shareholders). The business is considered to be more speculative if the gearing ratio is high, as it suggests that a larger amount of the business’ capital structure is based on debt and therefore subject to external forces that are not under its control. The higher the gearing, the more speculative or risky the company is to be perceived. This ratio also gives indication of the long-term financial stability of the business.

Debtor Days Collection Period
(Average Debtor Days / Credit Sales) x 365 (expressed as x number of days)
The Debtor days ratio gives us an indication of how long, on average, it takes for us to collect monies from our customers who have purchased on credit. The amount of debtor days usually under the control of the business and the lower the ratio this is, the better, as it facilitates good cashflow management.

Creditor Days Payment Period
(Average Creditors / Purchases) x 365 (expressed as x number of days)
This ratio gives us an indication of the average number of days the business is required to pay off liabilities owed to creditors, which could be suppliers, professional services etc. The higher this figure the better, as the longer we have to pay back liabilities, the better it is for us, as we are able to cash in money from our debtors to pay our creditors. This figure is usually under the control of creditors, but can sometimes, depending on the relationship, be negotiated.

There are a couple more, however these are some of the most important and widely used. I will write another post on other ratios including:

  • Return on Equity Employed
  • Stock Holding Period
  • Interest Cover
  • Earnings Per Share
  • Dividend Yield

Enjoy.

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The Balanced Scorecard is Really Useful. Here’s Why

The Balanced Scorecard. What is it? It’s a performance management framework alright – what’s that you ask? 

Probably one of the most useful frameworks around to support in the management of performance and strategy. The framework has been commended by both business people and academics alike.

Now, I’m not going to bore you with too many details but the Balanced Scorecard is essentially a tool that gives a company a template on how to manage both financial and non-financial strategic performance in line with goals and objectives that are set by the company or owner. Objectives, measures, targets and initiatives are set to implement, monitor and respond to, to ensure that the company is working towards it’s overall and longer-term objectives.

Now before we begin, it is probably worth defining, success.

  • Increased profits year on year?
  • A happy customer base?
  • A competent team?
  • Is it being efficient in all aspects of the company?
  • Or all of the above + more?

The Balanced Scorecard response to this question is that, all of the above definitions define success collectively. The Balanced Scorecard takes a “holistic” approach to strategic performance management, ie. managing different ‘dimensions’ of the business collectively, successfully.

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The Balanced Scorecard has four distinct sections to it and they are as follows:

  1. Financial – Focuses on financial objectives and ‘shareholder’ opinions of the organisation.
  2. Internal Business Processes – Focuses on the processes and systems in place to help the business excel.
  3. Learning and Growth – Focuses on the resources and infrastructure the company must establish and maintain to ensure growth, learning and development, resulting in innovation, effective team etc.
  4. Customer – Focuses on the approaches, processes and systems to ensure the customer is always satisfied.

The Balanced Scorecard poses a number of questions to Managers that contextualise the scorecards into a more accessible, friendly format, in order to allow Managers to better respond. The questions ask Managers to consider what metrics are important based on each scorecard. The questions are as follows with some example metrics:

  • Financial: “How should we appear to our Shareholders?”
    Example metrics include, ROI (%), Liquidity, Profitability Margins etc.
  • Internal Business Processes: “What business processes must we excel at?”
    Example metrics include processing times, individual steps needed for a process, wastage, errors etc.
  • Learning and Growth: “How will we sustain our ability to change and improve?”
    Example metrics include, Research and Development spend, innovative solutions, speed to market, corrective action response times and success rates etc.
  • Customers: “How should we appear to our customers?”
    Example metrics include delivery times, quality control, customer experience statistics etc.

In order for Managers to choose metrics that add real value, they must first understand what the company wants to achieve over the long term. With this knowledge, companies can then answer the above questions and choose measures, targets and initiatives to direct day-to-day activities that ultimately meet longer-term objectives.

For details and examples on the subheadings to each scorecard, with examples, please read this fabulous post, here.

The overall results of the implementation of the Balanced Scorecard can be improved processes, greater customer satisfaction, educated and motivated employees, better overall internal systems, increased and sustained profits and overall value added to all dimensions of the business. Why would you not want to use this tool to help determine what to monitor? It helps the company align its day-to-day operations with longer-term objectives and ambitions as all short-term objectives, targets and initiatives are based on long-term objectives.

You might be thinking, but why do I need this now? I’ve been doing just fine without a framework; indeed this is true but the point of the Balanced Scorecard is to provide a template on which to build upon. You may already be using the Balanced Scorecard unknowingly. The Balanced Scorecard simply provides a template, a structure, a guideline on how to structure performance management and strategy.
 
Related read: Balanced Scorecard In Detail.