It can be easy to simply steam ahead when you run your own business, taking the approach that you are busy so business must be good. Yet activity does not always equal profit. Therefore it makes sense to regularly review your business performance, after all if you’re working hard you want to ensure you are reaping the rewards.
A great way to monitor and assess the financial health of your business is to use some simple business ratios. You can compare your results with previous year results to see how you are tracking over time. Alternatively you can compare your ratio performance to your competitors. This will help you understand if your business is performing as well as it could or if there’s room for improvement.
There are different types of performance ratio’s you can choose to use depending on what aspect of your business you want to look at:-
- Profit Ratios – these look at the profitability of your business
- Liquidity Ratios – these assess the ability of your business to pay its debts
- Financial Ratios – these assess the funding position of your business
- Efficiency Ratios – these look at the efficiency of your business processes
By looking at a few ratios from each of the categories you can get a good understanding of your overall business performance.
1. Profit Ratios
Gross profit margin ratio
A gross profit margin ratio shows the proportion of profit for each sales dollar before expenses have been paid. An acceptable gross profit margin ratio varies from industry to industry but in general the higher the margin the better.
Gross profit margin = Gross Profit / Sales : 1.0
Net profit margin ratio
A net profit margin ratio shows the proportion of profit for each sales dollar after expenses have been paid. An acceptable net profit margin ratio varies from industry to industry but generally the higher the margin the better.
Net profit margin = Net Profit / Sales : 1.0
Gross profit vs net profit
The difference between your gross profit and net profit can easily be seen on your profit and loss statement. Your gross profit is your sales minus your cost of goods sold, but does not factor in your business operating expenses. Net profit is a truer indication of your profit, as it factors in both your cost of goods sold and your operating expenses.
Return on investment (ROI)
ROI shows how efficient your business is at generating profit from the original investment (equity) provided by the owners/shareholders. Lenders will also be interested in your ROI to help them determine the financial strength of your business.
ROI = Net Profit / Owner’s Equity
2. Liquidity Ratios
Current ratio/Working capital ratio
The current or working capital ratio works out your business liquidity — which is how quickly your business can convert assets into cash for the purpose of paying your current bills/liabilities. This ratio is a good measure of the financial strength of your business. For example, a ratio of 1:1 means you have no working capital left after paying bills. So generally, the higher the ratio, the better off your business will be. Lenders will also be interested in your current ratio to help them determine your capacity to repay a potential loan.
Current ratio = Current assets/ Current liabilities : 1.0
The quick ratio or acid test ratio is similar to the current ratio except that it excludes inventory, which can sometimes be slow moving. This ratio provides a much more conservative measure of the liquidity of a business. For example, a ratio of 1:1 means you have no working capital left after paying bills. So generally, the higher the ratio, the better off your business will be. Lenders will also be interested in your quick ratio to help them determine your capacity to repay a potential loan.
Quick ratio = (Current assets – Inventory) / Current liabilities : 1.0
3. Efficiency Ratios
Debt to equity ratio
The debt to equity ratio shows you what type of financing your business is more reliant on – debt or equity (private investment). A ratio of 1:1 means you have an equal proportion of both debt and equity. In general you want a mid-to-low level ratio. The higher the ratio, the higher risk your business is to lenders.
Debt to equity ratio = Total liabilities / Total equity : 1.0
Loan to Value Ratio
A Loan to Value Ratio (LVR) is the loan amount shown as a percentage of the market value of the property or asset that will be purchased. The ratio helps a lender work out if the loan amount can be recouped in the event a loan goes into default. The percentage lenders are willing to accept will vary but the lower the LVR, the better.
LVR = (Loan amount / Property or asset value) * 100
Figures are not everyone’s forte, so if you would like some independent, expert advice and guidance when it comes to your business performance then contact us today 08 9380 3555 for a FREE, no obligation catch up. We can help you review your business performance and identify opportunities for improvement.
Alternatively you can undertake our free online business improvement survey and receive a free detailed report on potential ways you can improve your business performance. Claim your free report today, the survey takes about 15 minutes to complete and you can stop and start as needed – Business improvement survey