Understanding Financial Ratios

Introduction

Looking at a profit and loss account and a balance sheet can give you a clear idea of the health of your business, but for many people these statements are somewhat daunting. However, calculating a few financial ratios can help you to assess quickly how well you are doing and give you early warning of financial problems.

This guide explains what ratios are, the types of information they can be used to analyse, and how to go about using them.

Different kinds of ratios. 

A ratio is simply a relationship between two numbers. Within your business, you can use ratios to assess the following important financial indicators:

  • Liquidity - the amount of working capital you have available.
  • Solvency - how near you may be to bankruptcy.
  • Efficiency - how good your management is.
  • Profitability- is your business a good investment?

Each of these is discussed in more detail below.

You can also compare your business's ratios with the same ratios for other businesses operating in a similar environment to you - giving an idea of your relative performance. Ratios are published for many business sectors (sometimes referred to as 'industry norms') which can be used as a comparison.

It is useful to compare ratios for different periods, to see what trends and patterns of performance emerge.

Liquidity ratios.

The current assets of your business are its cash or assets such as stock, work in progress, or debts that can be turned into cash. Current liabilities are your immediate trade creditors and your bank overdraft. You should always have sufficient current assets to meet current liability obligations. Liquidity ratios indicate your ability to meet liabilities.

Current ratio.
The current ratio simply shows the relationship of current assets to current liabilities. In particular, it shows the ability of your business to meet short-term debts with current assets.

 Current Ratio

This ratio should normally be between 1.5 and 2. Some people argue that the current ratio should be at least 2, on the basis that half the assets might be stock. A ratio of less than 1 (that is, where the current liabilities exceed the current assets) could mean that you are unable to meet debts as they fall due, in which case you are insolvent. A high current ratio could indicate that too much money is tied up in current assets, for example, giving customers too much credit.

Quick ratio (acid test).
A stricter test of liquidity is the quick ratio or acid test. This ratio measures your ability to meet short-term liabilities from liquid assets such as cash. Some current assets, such as work in progress and stock, may be difficult to turn quickly into cash. Deducting these from the current assets gives the quick assets.

 Quick ratio

The quick ratio should normally be around 0.7-1. To be absolutely safe, the quick ratio should be at least 1, which indicates that quick assets exceed current liabilities. If the current ratio is rising and the quick ratio is static, there is almost certainly a stockholding problem.

Defensive interval
The defensive interval is the best measure of impending insolvency and shows the number of days your business can exist if no more cash flows into it. As a guide, it should be 30-90 days, though it depends on the industry.

Solvency ratios.

If the net worth of your business becomes negative - that is, the total liabilities exceed the total assets - you have become insolvent. In other words, if you closed, it would not be possible to repay all the people who are owed money. It is an offence to allow yourself to become insolvent, so watch the figures closely.

Gearing ratio.

The gearing ratio gives an indication of solvency. It is normally defined as the ratio of debt (loans from all sources including debentures, term loans and overdraft) to total finance (which includes shareholders' capital, reserves, long-term debt and overdraft). The higher the proportion of loan finance, the higher the gearing.

 

 Ideally, your gearing should not be greater than 50%, although new, small businesses often do exceed this percentage. If cash flow is stable and profit is fairly stable, then you can afford a higher gearing.

 

Interest cover
In addition to watching the gearing of your business, bankers will also want to be satisfied that you will be able to pay the interest on any loans. So, they look particularly at how many times your profit exceeds their interest charges. A business with low interest cover may be unable to meet future payments if profits were to fall.

Generally, the measure of risk should not be decreasing. There is a problem if the interest cover is lower than 1, and this may indicate potential problems if interest rates were to rise. If it is more than 4, it is very good.
 
Dividend cover.
The dividend cover ratio is less important for small private businesses. It is the amount of times that dividends are covered by profits. The stock market benchmark is 2. If dividend cover is less than 1, nothing is being invested to help a business in the long term. However, if dividend cover is greater than 4, shareholders will feel that they are not getting their fair share of the profits.

Efficiency ratios

Efficiency ratios provide a measure of how much working capital is tied up, how quickly the business collects outstanding debts (and pays its creditors) and how effective the business is in making money work.

Debtors' turnover ratio
The debtors' turnover ratio shows how quickly you are collecting the debts that are due to you.

Ideally, the average debtors for the period should be used. An approximation is given by dividing the sales by the debtors at the end of the period. Dividing this ratio into 365 days gives the average collection period in days.

Tight credit control is essential to every business. The debtors' collection period measures how long it takes to collect cash from a customer after making a sale. The collection period should be kept as short as possible. Many businesses aim to operate on a 30-day period, but often find it is longer than that.
 
Creditors' payment period
Monitoring how long it takes to pay suppliers is as important as knowing how long customers take to pay you. If suppliers have to wait too long, they may withdraw credit facilities. The creditors' payment period measures how long you take to pay suppliers for items bought on credit.

Stock turnover ratio
Stock will increase in times of expansion and decrease in times of contraction. For some businesses, such as wholesalers and some retailers, a high stock turnover ratio is essential in order to make any profit. A low stock turnover could indicate the presence of slow moving stock, which should be disposed of more quickly.

It is also often helpful to know how quickly the stock is turned over, so you can use the following ratio to calculate your average stockholding period.

Profitability ratios

There are a number of simple profitability indicators that you can use; the gross profit margin is one figure to watch most closely.
 
Gross profit margin
The gross profit is the total income for the business less the cost of sales. The gross profit needs to cover all of the fixed costs and, after they have been paid, contributes to the net profit. The gross profit margin is simply the gross profit expressed as a percentage of sales. This is a good figure to compare with others in the same sector.

Net profit margin
The net profit of your business is what is left after all your costs (except interest and tax, neither of which are generally regarded as costs) have been deducted. The net profit margin is the net profit expressed as a percentage of sales.

Return on capital employed
Some funders will want to know the return on the capital you employ. This shows your ability to generate returns on the funds invested. It will show the element of risk involved in investing in your business. It can be compared with interest rates for investments where there is very low risk - for example, if the same sum of money had been put in a building society or invested on the stock market. For a small business, where the proportion of short term debt is high, you should include equity plus long term debt and short term debt when you calculate the figure for capital employed.

Limitations of ratio analysis

Ratio analysis is a very useful way to interpret your accounts. However, there are several limitations.

  • Inconsistency: When comparing ratios with other businesses, it is not possible to know whether the same accounting methods have been used, even though accounting principles and standards have been developed. Examples include methods of depreciation and stock valuation where different businesses may use different techniques.
  • Inflation: When ratios are being used to assess trends over a number of years, fluctuations could be due to inflation levels, rather than performance. This could result in misleading figures, so adjustments should be made to reflect the rate of inflation in the periods being considered.
  • Subjectivity: Conclusions drawn from accounting information will reflect any judgements made by those who prepared it. Some of the figures needed for the ratios may not be available, so alternatives will be used which are less precise. It is important to consider this when reading accounts from other businesses.

Despite these limitations, ratio analysis is a very useful method of analysing business performance if you compare your ratios to your past performance or to industry norms; don't use them in isolation.

Hints and tips

  • The key use of ratios is to examine trends and identify problems. Ratios will never solve problems but they might help to identify the factors behind your business's financial problems.
  • The smaller your business, the more important it is to watch the cash flow, rather than relying on ratio analysis.
  • Ratios depend upon accurate, consistent financial information, so keep your accounts up to date.

Further information

Books
'Key Management Ratios'
Ciaren Walsh 1997
Financial Times Prentice Hall
'Business Accounting'
Jill Hussey and Roger Hussey 1999
MacMillan Press Ltd
'Interpreting Company Reports and Accounts'
Geoffrey Holmes and Alan Sugden 1999
Prentice Hall
'Accounting and Finance for Non-Specialists'
Peter Atrill and Eddie McLaney 2000
Financial Times Prentice Hall
 
Useful Contacts
Centre for Interfirm Comparisons
The Centre for Interfirm Comparison helps businesses to improve their profitability and productivity by providing expertise in benchmarking, performance measurement and financial control.
 
32 St Thomas Street
Winchester
SO23 9HJ
Tel: (01962) 844144
Website: www.cifc.co.uk

© Cobweb Information Ltd 2003

 


 

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