Financial ratio analysis is a helpful tool that can be used to predict the success and measure the progress of your business, as well as spot warning signs. By spending time on financial ratio analysis, you will be able to identify trends in your business and use the results to improve overall performance.
Although you can use numerous financial ratios to assess the business’s health, here are a few important ones you can use easily. The ratios are grouped together under the key areas you should focus on. You can add most of these ratios to your dashboard in Xero by going to Accounting, reports, and business performance and selecting what you would like to track. There is also a new reporting add-on with graphs which makes it much easier to see what is happening in your business. If you would like to trial this reporting, please reach out, and we can add it to your Xero file.
Liquidity ratios assess if your business has adequate cash to pay debts as they fall due.
- Current Ratio is one of the most common measures of financial strength.
Current Ratio = Total Current Assets / Total Current Liabilities
This ratio measures whether the business has enough current assets to meet its due debts with some margin of safety. A current ratio of 2 to 1 is generally acceptable; however, it will depend on the nature of the industry and the form of its current assets and liabilities.
- Quick Ratio is one of the best measures of liquidity.
Quick Ratio = (Total Current Assets — Value of Stock on Hand) / Total Current Liabilities
This ratio measures real, liquid assets by excluding the value of stock. It helps determine if a business can meet its current obligations with funds that can be readily converted to cash even if it doesn’t receive income for a period of time.
Profitability ratios measure your business performance and the success of your business activities.
- Gross Margin calculation measures the percentage of sales dollars remaining (after obtaining or manufacturing the goods sold) available to pay the overhead expenses of the business.Gross Margin = Net Sales (after sales commission and discounts) / Cost of Goods sold
- The Net Margin measures the percentage of sales dollars left after all expenses (including stock), except income taxes. It is a good ratio for comparing your business’s return on income with the performance of similar businesses.Net Margin = Net Profit / Net Sales
Management ratios monitor how quickly you are replacing your stock and how often you are collecting debts outstanding from customers. These calculations provide an average that can be used to improve business performance.
- Stock Turnover shows you how many times you replace your stock during a time frame. It divides the cost of goods sold by average stock value.
Stock Turnover Ratio = Cost of Goods Sold / ((Opening stock + closing stock) x 0.5)
This ratio is important because it indicates how quickly stock is being replaced. Usually, the more times inventory can be turned in a given operating cycle, the greater the profit.
- Debtor Days show you the average number of days it takes to collect cash from your customers.
Annual Debtor Days = (Debtors / Net Sales) x 365
If payments from debtors are slow to be converted to cash, the cash flow of your business will be severely affected. Ideally, you want your debtor’s days to be as low as possible.
You can use many more financial ratios to measure your business’s performance. Don’t get too hung up on the calculations — there are a lot of calculators on the web you can use, and your accounting system may also do this for you. What is more important is that you analyse the results and take action when needed.
If you would like more details on how this can work for you & your business, remember that KBAS Bookkeeping is here to support your journey. To learn more about our services, reach out to us at firstname.lastname@example.org or phone: 07 5408 7400.