How to use financial ratios
A financial ratio is a calculation you use to identify either how well you are doing, or as a red flag to signal something needs addressing in the future.
It could something simple like comparing sales to marketing costs. For example, if this year's sales are $1m and you spent $50k on marketing, the marketing/sales ratio is 5% ($50k divided by $1m). You can now compare how effective your marketing is year to year, by seeing if the percentage changes (an increase could mean your tactics are less effective, as you’re spending more on marketing relative to sales).
Getting the most out of financial ratios
In most cases, the usefulness of financial ratios depends on a clear understanding of the relationship between the numbers used and their implications for your day-to-day business.
Ratios themselves are best at helping you identify why they may be changing, before you decide. There will be times when you’re comfortable with a deteriorating ratio if other parts of the business are succeeding. For example, if your turnover increases from $2 million to $3 million, and net profit rises from $200,000 to $250,000, you’ve made more money, but the actual profit/sales ratio has deteriorated. Year one profit to sales is 10% ($200k divided by $2m), and year two it’s fallen to 8.3% ($250k divided by $3m).
This may be ok as you’ve made an extra $50k in profit, but to generate that, you’ve needed to increase sales by $1m. This marketing budget increase could be fine if your overall net profit is also growing.
There are a number of ratios you could review, such as:
The current ratio is a measure of liquidity or the availability of cash (or assets that can be converted easily into cash) to run your business and meet its short-term obligations such as paying supplier invoices, wages, rent and any loan payments.
The calculation takes information from your balance sheet and is calculated by dividing current liabilities into current assets, to give you an idea of if you have enough assets to cover any debts. For example, if current assets are $500k and liabilities are $250k, then the ratio is 2:1 (twice as many assets than debts). This is probably fine. The reverse of course isn’t so good (twice as many debts than assets), where if you suddenly had to pay all your bills, you’d struggle, and may need additional financing capacity.
Gross profit ratio
This ratio measures your gross profit as a percentage of turnover. For example, if your turnover is $2 million and your cost of sales is $600k, you’ve made a gross profit of $1.4 million. It’s easy to turn this into a percentage: $1.4m divided by $2m equals 70%.
Every $100 of sales therefore generates $70 towards paying expenses and contributing to net profit. If this gross margin percentage starts to slip over time, it’s an indication that you need to find out why and take action. Reasons may include rising inventory costs, offering too many discounts, shrinkage (theft or wastage) or selling more products with lower margins.
To improve gross margin try increasing your prices, switching to lower cost materials or different components where possible, without affecting quality and put plans in place to minimize waste and theft.
Net profit margin
The net profit margin is the percentage of each dollar of sales that remains after all expenses have been deducted. For example, for a business with a turnover of $2m and a net profit of $300k, the net profit margin is 15% ($2m divided by $300k).
To improve net profit margin, some obvious solutions are to increase your price, lower overhead or focus on selling higher margin products and services.
Return on capital employed
This ratio helps show what return you’re making on the money financing the business (both as loans and shares). If you have $5 million in capital in the business, and earn $250k profit, this is a 5% return on capital invested ($250k divided by $5m). Would your capital earn better a return in another investment if you sold the business?
It’s not always practical of course to sell, and often you’re drawing a salary, wage or dividends from the business. But it could be worth the question if you have very large amounts of capital tied up in the business (like equipment) and you’re generating a very low return.
Expense to sales ratio
Take any expense and divide it by sales, to see how much each contributes to the success of the business. For example, you can see if your employee ratio is remaining stable, by dividing wages into sales. If the percentage is increasing, then you’re spending more on employees per dollar of sales than in the past.
Making use of your ratios
A ratio on its own is less useful than compared to your data from previous years, or data from similar businesses (which allows you to benchmark). If you can, find benchmarking data of businesses in your industry to find out where you’re doing well and where you should set improvement goals.