Want to know how your company is really doing? If so, looking at your gross sales and revenues is not enough. The secret is to look beyond the numbers and pay close attention to the relationships between the numbers. This White Paper tells you all about these relationships and what they can reveal about your business.
Ratios – the real performance indicators
In themselves, the raw numbers on your balance sheet, income statement and cash flow statement have limited value. Of far greater value, when it comes to evaluating your company's financial performance and making critical management decisions, are certain ratios that you can extract from these documents.
When tracked and measured on a regular basis, these key financial ratios allow you to:
- get a more accurate reading of your company's financial performance
- compare performance against the previous year, the current budget and your industry as a whole
- establish benchmarks to see where you are going and how you are doing.
The secret to effective financial management lies in knowing which ratios to track and what they tell you about the state of your business.
Too many CEOs look at gross sales and revenues on the income statement and nothing else. If sales look good, they figure everything else must be in order. In reality, you can have healthy sales growth and still be headed for financial disaster. The only way to know that is to pay attention to the ratios that tell you what's really going on in the business.
These ratios can be divided into three categories:
- Balance sheet ratios
- Profit and loss ratios
- Key operating ratios.
1. Balance sheet ratios
The balance sheet gives the truest picture of the overall health of the business. It acts as a snapshot, telling you where the business stands at a given point in time. Unlike the profit and loss (income) statement, which gives a historical record that never changes, the balance sheet is a living, breathing document that changes on a daily basis.
The three most important balance sheet ratios are as follows.
- Current ratio measures whether you have enough current assets (defined as anything that can be turned into cash within a year) to meet your current liabilities.
Current ratio formula: Current assets divided by current liabilities
- Quick ratio measures the company's ability to meet financial obligations using only liquid current assets: cash or assets that can be turned into cash within 90 days. (The quick ratio does not include inventory because, if you have to liquidate, you never get full value for inventory.)
Quick ratio formula: (Current assets minus inventory) divided by current liabilities
- Debt-to-equity ratio measures how much of the company is financed by borrowing versus owner equity. This ratio plays a major role in determining how much you can borrow and at what interest rate.
Debt-to-equity ratio formula: Net worth divided by total liabilities
Uses of balance sheet ratios
Balance sheet ratios are crucial because they measure the amount of risk in the business. The current and quick ratios (also known as liquidity ratios) measure the company's ability to survive a short-term financial crisis. The debt-to-equity ratio (also known as the safety ratio) measures the company's ability to survive over the long term.
If sales and revenues continue to climb while these three measures show a decline – a frequent scenario in fast-growth companies – you have a real problem on your hands.
2. Profit and loss ratios
The profit and loss (P&L) statement focuses on revenues, expenses and net income (or loss) over a defined period of time. It measures the company's ability to turn sales and revenues into profits – a key ingredient for long-term success.
The most important P&L ratios include the following.
- Gross profit ratio measures how much money you bring in after subtracting the costs of goods sold.
Gross profit ratio formula: Revenues minus cost of goods sold
- Gross margin ratio measures how much it costs to obtain sales.
Gross margin ratio formula:Net sales minus cost of goods sold
- Net operating profit ratio represents how much money you have left over, before interest, depreciation and taxes, after all expenses are taken out. Some people also refer to this as EBITDA (earnings before interest, taxes, depreciation and amortisation).
Net operating profit ratio formula:Gross margin minus selling, general and administrative expenses
- Net profit ratio measures how much money is left over after all expenses are taken out.
Net profit ratio formula: (Net operating profit plus income) minus (other expenses plus taxes)
Uses of profit and loss ratios
In our opinion, gross margin (and its relationship to expenses) is the most important P&L ratio. You need to pay attention to all of the P&L ratios, because they affect your profitability. But if you lose the gross margin battle, you can do a lot of other things right and still go out of business.
You can have a high gross margin and still have expenses higher than your gross margin. The key is the relationship of gross margin to expenses.
3. Key operating ratios
The following ratios combine information from the balance sheet and income statement to provide a more sophisticated picture of what is happening in the business.
- Gross profit ratio measures the percentage of every £ of sales that becomes gross profit. For example, a gross profit ratio of 40% means that you earn 40 pence at the gross profit level for every £ of sales.
Gross profit ratio formula: Gross profit divided by sales
- Pre-tax profit ratio measures how much you make at the net profit level for every £ of sales you generate.
Pre-tax profit ratio formula: Pre-tax profit divided by sales
- Sales-to-assets ratio measures the amount of sales generated for every £ of assets employed in the business. For example, a sales-to-assets ratio of 2.5 means that you generate £2.50 in sales for every £ of assets in the business.
Sales-to-assets ratio formula: Total assets divided by sales
- Return on assets ratio measures how much profit you generate for every £ in assets.
Return on assets ratio formula: Pre-tax profits divided by total assets
- Return on equity ratio measures the return on every £ you have invested in the business.
Return on equity ratio formula: Pre-tax profit divided by equity
- Inventory turnover ratio measures how many times a year you turn over your inventory. If you use sales cost, you must also use inventory cost. If you use selling price (which retail businesses typically do), you must also use inventory selling price. You can use either cost or selling price, so long as you are consistent.
Inventory turnover ratio formula: Sales divided by average inventory
- Days in inventory ratio measures how long, on average, it takes to turn over your inventory.
Days in inventory ratio formula: Inventory turnover divided by 365 days
- Accounts receivable turnover ratio measures how many times a year you collect your accounts receivable.
Accounts receivable turnover ratio formula: Sales divided by accounts receivable
- Collection period ratio measures how often, on average, you collect your accounts receivable.
Collection period ratio formula: Accounts receivable turnover divided by 365 days
- Accounts payable turnover ratio measures how many times a year you pay your accounts payable. As with the inventory turnover ratio, you can use cost or selling price, as long as you use the same factor on both sides of the equation.
Accounts payable turnover ratio formula: Cost of goods sold divided by average accounts payable
- Payable period ratio measures, on average, how often you pay your accounts payable.
Payable period ratio formula: Accounts payable turnover divided by 365 days
Uses of key operating ratios
Why bother tracking these seemingly arcane ratios? Because they tell you how efficient your company is at generating and using cash. More important, they tell you what's happening to your cash flow.
The raw numbers on the monthly cash flow statement are important because they tell you how much cash you have on hand and how the cash got used last month. But these operating ratios tell you what's going to happen to your cash flow in the near future. If you're going to run out of cash, you need to know while you still have time to do something about it.
How to get better ratios
The whole purpose of studying ratios is to make them better. To improve your ratios, we recommend the following.
To improve your balance sheet ratios:
- Speed up inventory turnover. This improves cash flow and reduces risk, because inventory always carries a certain amount of obsolescence risk.
- Consider leasing rather than purchasing equipment. In many cases leasing is more cost effective, especially if the technology is changing quickly in your industry.
- Reduce the time it takes to collect receivables. This is one of the easiest ways to increase cash flow, if you pay attention to it.
- Get increased day terms. If you can extend your payables to 60 or 90 days without increasing the cost of goods, in essence you get your vendors to finance the business. However, get your price first and then go for additional days.
To improve your profit and loss ratios:
- Leverage sales over fixed costs. Strive to get more effective and efficient so that you can improve sales without increasing costs. We recommend the following:
- Sell more to existing customers.
- Work on closing skills.
- Sell at the right level. Don't waste time trying to sell to people who can't make the decision.
- Identify segments of your business where more potential exists.
- Review how you incentivise your sales mix. Make sure the compensation programme for your sales team is in alignment with the best interests of the company.
- Pay sales people for receivables that get collected, not just for making sales.
- Hold the sales team accountable for desired results.
- Increase gross margins. We suggest attacking margins from three angles:
- Cost. Constantly work to lower your cost of goods sold.
- Value. Are you getting paid for all the value you provide customers?
- Velocity. The faster you move things through the business, the faster you collect cash. Focus on increasing velocity to generate more cash and improve margins.
- Review pricing opportunities. Consider giving lower costs in rebate form after customers achieve certain purchasing levels. This allows you to keep the cash flow while forcing customers to buy more in order to receive the discount.
- Use zero-based budgeting. Don't let your people automatically submit budget increases every year. Instead, have them start with a blank piece of paper and cost-justify everything they do.
- Compensate people for productivity rather than time. Have some element in your compensation programme that is tied to productivity. When you pay for time, you get time, which requires more supervision and increases costs.
- Outsource when it's economically advantageous. Study your non-core processes and look for things that other companies can do more cheaply. Conversely, there may be things you are so good at that you can do them for other companies.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.