Key accounting ratios

The use of some basic measures can help you monitor your business’s performance and make best use of the financial information you have available.

The records you keep allow you to look at a great deal of information about your business. Details of sales made to customers, purchases made from suppliers and payments made to employees can be used to see how the business is doing. Just as importantly, the information can be used to compare the performance of the business with its previous track record and with the performance of other similar businesses.

By using a broad range of measures, comparisons can be made to review how profitable the business is, how efficiently it is performing, and whether it is able to pay its bills on time.

Business ratios provide an opportunity to interpret financial data, adding to the key information held on the most important aspects of the business. Better information helps you to make better decisions about where to take your business in the future.

This guide identifies the key elements of what to monitor and how to interpret the information. Remember that with most of these measures, the trend over time is often more revealing than one figure in isolation.

Is the business solvent?

A business is solvent when it can pay its debts as they become due.

In day-to-day terms, this means it can pay its suppliers by having enough working capital.

There are two key ratios that help us determine whether a business is showing a solvent position:

• Current ratio
• Quick ratio

The current ratio looks at the relationship between current assets and current liabilities. These figures are always shown on the balance sheet and the ratio is calculated as follows:

Current ratio = current assets ÷ current liabilities

Current assets include: stock, debtors and cash. Current liabilities include: trade creditors, current tax liabilities, bank overdraft, etc.

The word ‘current’ implies short-term assets or liabilities, payable or receivable within one year.

If, as an example, current assets totalled £40,000 and current liabilities £20,000, then the current ratio would be:

Current ratio = £40,000 ÷ £20,000 = 2:1

This would be considered a healthy result showing that current assets are sufficient to pay current liabilities as they fall due.

Historically, a ratio below 2:1 gave cause for concern about the ability of a business to meet its debts and trade successfully, but more recently businesses are tending to work within a ratio of 1:1.

The quick ratio, or liquidity ratio, is useful as it measures liquidity more precisely than the current ratio.

This is because it ignores the value of stock within current assets.

Turning stock into cash takes time as cash from any sale will only be received in accordance with the trading terms of the company. This could be over 30 days.
The quick ratio is calculated by dividing current assets (without stock) by current liabilities:

Quick ratio = current assets less stock ÷ current liabilities

Using the figures from the example shown for the current ratio, and assuming the value of stock to be £10,000, we see the quick ratio would be:

Quick ratio = (£40,000 - £10,000) ÷ £20,000
= £30,000 ÷ £20,000
= 1.5:1

Historically this would also be looked at as a satisfactory result, but again businesses are tending to work with a lower ratio.

When reviewing the liquidity of a business it is usual to look at both the current ratio and quick ratio.

For example, a business may look healthy using the current ratio, but may be carrying too much stock. The difficulty would be that an apparently healthy level of current assets might hide the fact that a large proportion of the current assets were stock. Stock can be turned into cash – but only over time.

Is the business profitable?

You can see if a business is profitable by preparing a profit and loss account, but you need to put that profit into perspective. Ask yourself:

• Is the profit growing in proportion to the size of the business?
• Is the profit growing or falling in relative terms – are you making as much profit on extra sales as you were on existing sales?
• Is the business as profitable as other businesses in the same sector?

The size of a business is often measured by looking at:

• Levels of turnover
• Value of assets
• Amount of capital invested in the business
• Number of employees

You need to put the profit in perspective and can do this by looking at various ratios, which compare profit as a percentage of sales or assets.

Gross profit margin

One of the most commonly-used ratios is the gross profit margin, which looks at the gross profit as a percentage of turnover.

Gross Profit % = gross profit ÷ turnover x100

If a business makes a gross profit of £45,000 from sales of £135,000, the calculation will be:

£45,000 ÷ £135,000 x 100 = 30%

What does this mean?

Effectively, it means that for every £1 of sales the business achieves, profit after taking off the costs of production is 30p.

Small changes in this percentage can indicate that your costs of production are creeping up, prompting you to consider increasing prices or look for cheaper suppliers.

Your gross profit margin is not the same as your mark up, which is calculated as follows:

Mark up = Gross Profit ÷Cost of Sales x100

So for the previous example, this would be:

Mark up = 45,000 ÷ 90,000 x 100 = 50%

Net profit margin

This ratio is similar to the gross profit margin and looks at net profit as a percentage of turnover.

Net profit % = net profit ÷ turnover x 100

As an example, if the business makes net profits of £20,000 from a turnover of £100,000, the net profit percentage would be calculated:

Net profit % = £20,000 ÷ £100,000 x 100 = 20%

The ratio provides a good measure of performance, but if the percentage is declining it is subject to many variable elements, making it difficult to correct.

The net profit is calculated after taking account of all costs and may be affected by a declining gross profit (see above) or by increased costs within the business. It is probably worth looking at your costs on an individual basis to see which have proportionately increased the most. Is there any way you can reduce these?

The important element with this as with the other ratios is to look at the trend, which emerges over several accounting periods.

The ratios can be used to measure periods other than a full year, so long as you have the data to work out the figures.

Return on assets

You can measure the level of profit compared to the value of net assets invested in your business.

The assets are the major items that need to be in place to do business, including fixed assets (buildings, plant, vehicles, computers) and current assets (stock, debtors, cash).

The net asset total looks at total assets less liabilities. This represents the amount of capital invested in the business.

You can therefore look at the net profit as a percentage of capital employed.

The return that a business can expect differs by business sector and differs over time – depending on the economic cycle. However, it remains a good measure of business efficiency.

The ratio is calculated:

Return on assets = net profit ÷ net assets x 100

If the net profit was £20,000 as shown in the profit and loss account, and net assets were £200,000, then the return on assets would be:

Return on assets = £20,000 ÷ £200,000 x 100 = 10%

How is the business performing?

There are several ratios used to measure how individual aspects of a business are performing.

You have looked at the big measures: can you pay the bills as they fall due? Are we making the sort of profit at the gross or net level that we expected to or that we used to?

By looking at individual parts of the business, you can see how efficiently your business is operating.

These ratios include:

The borrowing ratio (gearing)

This ratio looks at total borrowings divided by net worth of the business and shows the level of security there is for borrowings.

For example, if borrowings totalled £30,000 and the business net worth (as shown in the balance sheet) was £90,000, then the borrowing ratio would be 1:3. This is generally seen as good; usually bankers and financiers like to see this ratio at a level of at least 1:1.

Average collection period (debtor days)

This ratio is used widely within businesses to measure the effectiveness of their debt collection routines.

It sets out the relationship between debtors and the sales that have been made on credit.

It also shows how quickly customers are paying their invoices.

The calculation appears:

Debtor days = debtors ÷ turnover x 365

This calculation is a somewhat broad brush and a more detailed calculation would look at how many days’ turnover it took to make up the debtor total.

For example:

Debtors therefore represent all of the current month’s sales and half of the previous month’s sales.

If the current month includes 31 days, and the previous month was 30 days, total debtor days would appear:

If this ratio starts to increase, look carefully at your debtor collection routines.

Are you chasing money in quickly enough? Is one of your customers building up a large debt that you are not happy with? If so, take action.

Average credit period – creditor days

This ratio sets out the number of days taken to pay suppliers. This is less important than the debtor day statistic as the control over payment of suppliers is in your hands.

When assessing another business, for example one that is asking you for increased credit, this ratio can give a useful pointer as to whether the business is taking longer to pay people. Outside credit reference agencies use the calculations to give a profile of the business to potential suppliers looking for details about a business.

The ratio is calculated:

Creditor days = creditors ÷ purchases x 365

Stock turnover

Broadly this ratio looks at how quickly you turn over stock into sales. So again it is a good measure of efficiency.

The ratio can be calculated:

Stock turnover = cost of goods sold ÷ stock value

For example, if the cost of goods sold is £50,000, and the average stock held during the year is £10,000, then stock has been ‘turned over’ five times during the year.

The quicker that stock is turned over, the better. A quick turnover suggests that the business is efficient in holding the minimum stock used within the business.

Again, the trend over time is very important. If you are turning over your stock slower, why is this? For example, is some of it not easily saleable? If so, might it be better to sell it at a discount?

Overheads as a percentage of turnover

Again, reviewing overheads in relationship to turnover can be a useful tool in assessing whether they are growing more rapidly than they should.

The calculation is: overheads ÷ turnover x 100

The calculation means little on its own, but when reviewed over several periods can provide useful trend information.

As the business grows, this percentage should fall. If it doesn’t, then review your overhead costs carefully to understand why this is happening and see if there is anything you can do to correct it. For example, if your telephone costs are increasing, investigate the idea of switching suppliers.