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 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