Key Analytic Ratios for a Business
Adam Stannett:
Hi guys, welcome to this week’s vlog. This week, we’re going to be chatting about key analytic ratios for your business. My name is Adam. This is Lewis, and we’re just going to talk about basically what ratios you should really be looking at when you look at your balance sheet, your income statement, and basically what’s realistic and what we think is pretty important to you to know how your business is going. Lewis, do you want to start us off?
Lewis Milne:
Yes. One important thing to look at is the liquidity. So this is how easily you can turn assets into cash. So the ratio that we can use for this is your current assets divided by your current liabilities. A general baseline for this would be a two to one ratio of assets versus liabilities here, and that shows just your business is in good stead with a healthy assets to liabilities.
Adam Stannett:
Yeah, so that basically means that you’ve got two times coverage of your bills. So if someone was to call the bill, it’s not an issue. You’ve got cash on hand or cash alternatives, and that all you have stocked, they can readily convert. So that’s a very, very important ratio to be looking at basically for financial help. So moving on from that one, another really good one on the balance sheet to look at is return on equity. And basically, this one looks at your net profit divided by shareholder equity. Obviously, this one is mainly for companies. You can also do it with trust to a certain extent, depending on how you value stuff. But basically, that’s just investor returns after tax. So if you’ve got $100,000 of share capital on the balance sheet and you have a net profit of $100,000, well then it’s a one to one ratio. Obviously the higher the ratio, the better. It means the business is doing well and it can present a lot more returns for investors.
Lewis Milne:
Yeah. Awesome. Another good one is on the growth rate on the income statement. So the net earnings and net income comparing with previous years, it’s always good to see if they’re both growing over time. Usually, these two metrics should move pretty closely together.
Adam Stannett:
Yeah.
Lewis Milne:
So yeah, it shows if you have good growth over time. Another good one is the growth rate on the income statement. So here you can look at the growth in net income and also net earnings. So these two should move pretty closely along with each other. And you should be able to compare for the past five years and see if companies are actually growing rather than staying the same, or even if it’s on the decline. So if you have growth within those two metrics, that’s awesome to tell that your business is moving to the right direction.
Adam Stannett:
Yeah, absolutely. So another one we can look at very easily is the gross profit ratio. So total sales minus your cost of sales, cost of goods sold, divided by sales again. So basically this is top line sales, how much money you’ve made, and then minusing off the cost to generate that. So obviously the higher the ratio, the better. It means that you’re making money, but less expenses essentially. So if that one is always trending up, that’s great. If it’s a bit… Like, these ratios will vary from industry to industry. So some industries are really good GP, it might be 20%. One, another industry, it might be 50%. It’s really up to your industry. But it’s a very good one to quickly see, am I covering the cost to produce my product? Leading on from that one, the next one would be net profit ratio.
So that is basically after I paid the bills, what am I left with? It’s like, so that is net profit. So that is basically all your income minus all your expenses divided by your sales again. So this one is so you really want to be looking in tandem with the GDP ratio. If both of these are trending up, great. If one is trending up, mainly the GP is trending up a lot faster than NP, then you might have some leakage, some expenses there, because they should be moving in tandem. So if one’s going up, one’s going down, something’s going wrong. And you should take a closer look at your expenses, so you get them under control and just find out if you have leakage or if something’s just not being recognized properly.
Lewis Milne:
Yep. Awesome. Another good one to look at is the return of assets. So this is calculated by net income over total assets. Good baseline to look at is 5%, which usually is considered all right. Some companies can range up to 30%, which shows that they’re generating a lot of income with the assets that they have. So if you have anything over 5%, it’s considered positive. And then obviously that could range up to 30% with some real successful companies.
Adam Stannett:
Yeah. And that’s basically looking at how hard your assets are basically working for you.
Lewis Milne:
Yeah.
Adam Stannett:
Another to look at, particularly if you’re in sort of retail or hospitality, and it’s what I would call from my next day’s sales per crew. And that one is a very simple calculation. That’s total amount of sales you’ve had divided by the average number of employees you had on the floor. And that will tell you basically how much money each employee is generating for you. So obviously the higher the number, the better within reason. If your target, for instance, is $100 and you are doing $400, something’s wrong. You’re going to be understaffed and people probably aren’t going to be enjoying or having a fun time at work. So generally benchmark what your industry is, find out what it is, try and stay close to that as guideline.
Another one from that for hospitality is inventory turnover, so that’s cost of goods sold divided by average inventory. And this is a key one if you’re in retail, hospitality, anything with perishable goods. Basically, this is how quickly you basically clear your inventory and get it in. So for instance, say a 50 grand at inventory. Basically, if you have a turnover of say five times throughout the year, that means you turn over the inventory five times. That’s basically what you want. You want high turnover when it comes to that, because it means you’re getting everything out of the door quickly in that.
Lewis Milne:
Awesome. Another good indicator is the cash flow statement. So this looks at the operating cashflow subtracts by money used to purchase equipment. Generally, a good guideline for this is having the greater than one. Another good one is the cashflow statement, so this is operating income minus the purchasing of equipment. So if a company has a lot of cashflow, it means that they can meet those short term financial obligations. Whereas if they didn’t have this cash flow readily available, then financial crisis such as COVID, which just occurred, that’s when companies could get caught in a little bit of trouble. So if they have a lot of cash flow readily available, this is always a good thing.
Adam Stannett:
Yeah. So if you have positive cash flow, it means money is always coming in.
Lewis Milne:
Yeah.
Adam Stannett:
For instance, if you have COVID, you’re going to have a large amount of outgoings but very little incoming, and that’s fine. You can manage that short term through debt financing, if needed. But obviously, getting back to positive cashflow is important because that means you got money coming in. Two ratios you can look at that if you are having negative cashflow, basically have your accounts receivable turnover. So that’s basically how quickly am I getting paid? So obviously, you want a high turnover because you want to be getting paid quickly. So basically, you send the bill out on account, you get paid within your credit terms. Now, these can vary from industry to industry. Some might be 30 day terms. Some can even blow out to 90 day terms.
But the key to this one is you need to get paid quickly, and just constantly focusing on getting the money in. Because if you’re not getting paid, it means you might not be able to pay your employees, which is never a good thing. Or you might not be able to pay your creditors, which is the other side of the equation. So your days outstanding, and that is how long it takes you to pay a bill. Now, again, depending on the industry, you could also have 30-day terms, six-year terms, 90-day terms or more. Worst case scenario, if your cashflow is terrible and you’re being terrible with days outstanding, you may lose your account and your credit terms. You may have just stop paying on delivery or when you place the order. Positive cashflow wise, the easiest way to do this is make sure that your accounts receivable turnover is lower than your days outstanding.
So obviously, your money’s coming in quicker than it’s going out. So if your turnover’s high and your days outstanding is also high, then it’s fine. So if you’ve got your accounts receivables at 20 days and your days outstanding for payables is at 30 days, that’s fine. That means you’ve got 10 days there where you’ve got basically nothing outgoing really. So the gist of it is, get paid first before you pay something else.
Lewis Milne:
Yeah.
Adam Stannett:
Cool. So that’s pretty much us for today, guys. If you want to schedule a meeting, talk more about ratios, see if we can provide any more advice, if we perked your interest, feel free to either give us a call, shoot us an email, or we put the live chat on the website as well. Cheers.
Lewis Milne:
Thanks.
