Key Financial Ratios
A broad overview of some key ratios and a framework for calculating ability to service your borrowing.
Using the information below, calculate and then consider these key ratios and what these show about your business.
Analysing trends over periods/years usually proves most useful.
- 1. Jump to Current Ratio
- 2. Jump to Quick ratio (acid test ratio)
- 3. Jump to Gross profit margin
- 4. Jump to Breaking-even point
- 5. Jump to Net profit margin
- 6. Jump to Return on Capital Employed (ROCE)
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 and so on.
Historically, a ratio below 2:1 would have given cause for concern about the ability of a business to meet its debts and trade successfully. Today, businesses tend to work within a ratio of 1:1.
Quick ratio (acid test ratio)
The quick ratio, or acid test ratio, is useful as it measures liquidity more precisely than the current ratio.
This is because it does not include the value of stock within current assets. Turning stock into cash takes time, with payment terms typically standing at 30 days or more.
So you calculate the quick ratio by dividing current assets (without stock) by current liabilities:
- Quick ratio = current assets less stock / current liabilities
When reviewing the liquidity of a business, it is common practice to look at both the current ratio and quick ratio. For example, a business may look healthy using the current ratio, but this won’t show if it’s carrying too much stock.
An apparently healthy level of current assets might hide the fact that a large proportion of the current assets is made up of stock. Stock can usually be turned into cash — but only over time, and to do it quickly might require discounting.
Gross profit margin
One of the most commonly used ratios is the gross profit margin, which looks at gross profit as a percentage of turnover:
- Gross profit % = gross profit / turnover x 100
Small changes in this percentage can indicate that costs of production are creeping up, which should prompt a consideration of increasing prices or looking for cheaper suppliers.
Gross profit margin can also be used to calculate your break-even point, i.e. the level of sales you need to achieve to make a profit:
- Break-even = fixed expenses / gross margin
For example, for a business with fixed expenses of £50,000 and a gross margin of 40 per cent, break- even would be at £125,000 of sales.
Net profit margin
This ratio is similar to the gross profit margin, but looks at net profit as a percentage of turnover.
- Net profit % = net profit / turnover x 100
This 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 or by increased selling or administration costs within the business. If net profit percentage is declining it is worth looking at costs on an individual basis to see what can be done about those that have increased the most proportionally.
It is important to look at the trend which emerges over several accounting periods, as opposed to individual figures.
The ratios can be used to measure periods other than a full year, as long as you have the data to work out the figures.
Return on Capital Employed (ROCE)
You can also measure the level of profit compared to the value of net assets invested in the business.
The net asset total looks at total assets less liabilities. This represents the amount of capital invested in the business.
The return that a business can expect differs by business sector and varies over time, depending on the economic cycle. However, it remains a good measure of business efficiency.
The ratio is calculated:
- Return on Capital Employed = 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%
This ratio looks at total borrowings divided by net worth of the business. The idea is that the relationship between borrowings and equity should be in balance, with equity being significantly higher than debt.
For example, if your borrowings come to £30,000 and the business’s net worth (as shown in the balance sheet) is £90,000, then the borrowing ratio would be 1:3. This would be positive: usually bankers and financiers like to see this ratio at a level of at least 1:1.
This ratio is used widely within businesses to measure the effectiveness of a debt collection routine. It sets out the relationship between debtors and the sales that have been made on credit, and also shows how quickly customers are paying their invoices.
The calculation is:
- Debtor days = debtors / turnover x 365
This ratio sets out the number of days taken to pay suppliers. This is less important than the debtor day statistic, as in this case 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
This ratio looks at how quickly you turn over stock into sales, and is another good measure of efficiency:
- 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.
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 your stock turn is slowing, this may highlight a problem with slow-moving lines which may require discounting to sell through.
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 it can provide useful trend information.
As a business grows, this percentage should fall. If it doesn’t, then a review of overhead costs is needed to understand why this is happening and see what can be done to correct it.
Simple Service Calculation
Simple Service Calculation
Net Profit Before Tax (NPBT)* / Retained Profit (RP)**
+ Interest Costs
+ Loss / - profit from sale of fixed assets
= Adjusted Profit before debt servicing & drawings
- Drawings & Tax
- HP Repayments
= Surplus/deficit available to meet repayments to Bank
Total Bank annual loan repayments
The above calculation is a simple way to assess a business’ ability to service repayments to the Bank, and the surplus margin for comfort.
If a business is planning to purchase premises rather than rent, as at present, then annual rent payments can be added back to NPBT above.
*NPBT - for sole trader & partnerships
**RP - for limited company (post dividends)
It’s also worth considering what profits / cash could be required for:
> Working Capital Requirements — for a growing business, increased turnover normally leads to increased cash being tied up in working capital (e.g. debtors & stock). So the cash surplus shown above may not be all available to service debt
> Capital Expenditure Requirements
> Consider what personal income is needed from the business via drawings, directors pay and dividends.
Important legal information
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This page provides you with steps that could be taken during a period of cash flow pressure within a business. It is not designed to constitute legal advice and as such if your business is experiencing financial difficulty it is recommended that you always seek independent legal and financial advice.
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