Analysing your business’s financial performance: understanding the basic ratios
To determine your financial performance, you should know how to read your financial statements and extract key information to determine your sales optimisation, profitability, liquidity, solvency and efficiency levels.
• Such financial analysis is not only valuable to you but also to your investors, who will base their decision on whether to invest capital in your business on your current and potential future performance.
• Sources for your financial analysis are usually found within:
— your financial statements
— industry associations – for example, the local chamber of commerce, SME initiatives or entrepreneurs’ initiatives – providing more stakeholder view and relevant information for SMEs in general
— various financial databases such as Reuters
— industry reports – reports providing insight or forecasts on specific sectors
— press releases.
• Make sure you are consistent with units (thousand, million or billion), currency and decimal places in your analyses.
The three basic financial statements described are critical to financial ratio analysis. Financial ratios compare items from those three financial statements to reveal how well you are managing your business and how strong your position is.
• The profit and loss statement will help you to assess the financial performance of a business during a given period of time. Make sure you understand your revenues (understand the industry and revenue model of your business), expenses (once you understand your business model, you will know the major operating expenses) and profitability (how sound your investments are).
• Your balance sheet will help you determine what you owe and what you own, and tell you where the business stands as of a particular date. This will also help you understand the capital structure of your business and why your business takes on debt.
• The cash flow statement tells you whether cash is coming in or going out. It captures only cash transactions and includes the income statement and balance sheet items. This can help you spot changes in working capital, investment and financing activities.
Your assessment should not be limited to a single year. Usually it is best to provide an overview covering three or more consecutive periods to properly spot trends. The assessment should be relative to your industry, including comparisons with peers and competitors.
Ratio analysis can be useful to predict the future performance of a business. A successful business will have solid financial ratios in all areas. Critical issues can be identified in areas where ratios are considered to be underperforming.
• Ratio analyses are rough diagnosis tools which may help you to determine the strengths and weaknesses of a business. They may identify areas to analyse in detail, but they are limited by the financial statements from which they are calculated. In particular, when calculating ratios, care needs to be exercised in deciding whether to use the data from the financial statements, or data adjusted to market values or to take account of certain facts and circumstances, such as missing assets.
• As a rule, when analysing ratios, the financial analysis ratios may vary depending on the business’s industry or economic cycles and the accounting principles applied.
Use this template to calculate key ratios from the financial statements, such as working capital ratios and the cash conversion cycle.
1. Sales calculations
By using sales calculation ratios you can easily determine whether the price of your goods or services is at the right level to cover your costs.
A break-even formula can help you determine how many units you have to sell to cover your production costs – in other words, to break even. Everything above the calculated target will represent the profit.
• Break-even point = total fixed costs ÷ (average price of each product or service – average cost of each product or service to make or deliver)
Illustrative example of how to calculate the break-even point
A margin indicates the percentage you earn on each sale you make.
• Margin = ((sales revenue – cost of goods sold) ÷ sales revenue) x 100
A mark-up calculation helps you set the price of your products or services as it represents the percentage added on top of your cost of goods sold.
• Mark-up = ((sales revenue – cost of goods sold) ÷ cost of goods sold) x 100
2. Profitability ratios
Profitability analysis helps you understand business’s ability to generate profit from capital.
• Profitability ratios are quantitative characteristics of the effectiveness of income from sales, share capital, liabilities and assets of the business.
Profitability ratios make sense only if the business makes profit: the higher the better. If the financial result is negative – representing a loss – then the profitability ratio is also negative. This group of ratios is not useful unless compared to a past year’s equivalent numbers. Profitability ratios are not directly relevant to insolvency – even when profits arise, insolvency can appear and vice versa.
Gross profit margin ratio
The gross profit margin ratio shows how much profit is generated from your cost of goods sold. This does not take into consideration your other operating expenses.
• Gross profit margin = gross profit ÷ sales revenue
Operating profit margin ratio
The operating (net) profit margin shows how effective the business is at converting revenue into profit.
• Operating profit margin = operating profit ÷ sales revenue
Return on investment (ROI)
Return on investment (ROI) or return on equity measures a business’s profitability by revealing how much profit a business generates with the money that has been invested.
• ROI = net profit ÷ owner's equity
3. Liquidity ratios
Liquidity analysis helps you understand a business’s ability to pay debt obligations. Current liabilities are analysed in relation to liquid assets to evaluate the coverage of short-term debts.
• The liquidity ratios are the quantitative characteristics of the ability of a business to pay its current short-term liabilities with its short-term (current) assets. They provide a general idea about the capability of the business to cover the liabilities on time and with satisfactory certainty.
Liquidity is sufficient when the assets are equal to or more than the corresponding liabilities. This means that the liquidity ratios should be greater than or equal to 1. In such cases it is assumed that the business does not have liquidity problems.
• The ratios vary across the different industries and throughout the economic cycle.
• Always take into account that the ratios alone are not always unconditional or sufficient evidence of insolvency. Review all the facts and circumstances applicable to a business order to determine whether the definition of insolvency is met – more precisely, whether it has encountered an irreversible situation leading to the inability to repay its current liabilities.
• Even if the liquidity ratios are below the accepted normal levels, theoretically, it is possible to prove that the business is able to repay its current liabilities (for example if there is a large enough unused overdraft). Conversely, even if the liquidity ratios are above the accepted normal levels, the business may not be able to repay its current liabilities because, for example, a state authority has revoked its license for business activities.
It is useful to know if an entity has recently received a bank loan. In most cases, banks require borrowers to maintain certain levels of liquidity ratios to ensure that the entity is in a good financial condition. In such cases it is recommended when analysing the liquidity to use as a reference point the ratios stated in the bank loan agreement. This may be a task for a professional accountant.
The current ratio measures the ratio of current assets (excluding deferred expenses) to current liabilities (excluding deferred revenue).
• The current ratio indicates whether the business is in a position to meet its short-term obligations with its current assets.
• Current ratio = current assets ÷ current liabilities
Quick ratio or acid test ratio
The quick ratio or acid test ratio evaluates your cash resources relative to cash obligations.
• The quick ratio or acid test ratio is a more stringent test of liquidity in relation to the current ratio. Ratios of less than 1 mean a business cannot pay its current liabilities and should be looked at with caution. If the acid test ratio is much lower than the current ratio, it means current assets are highly dependent on inventory.
• Quick ratio = (current assets – inventory) ÷ current liabilities
4. Solvency (financing leverage) ratios
Solvency analysis provides a measurement of how likely a business will be to continue to meet its debt obligations.
Debt to equity ratio
The debt to equity ratio measures the business’s financial leverage and indicates what proportion of equity and debt the business is using to finance its assets.
• Debt to equity ratio = total liabilities ÷ total equity
• A high debt to equity ratio generally means that a business has been aggressive in financing its growth with debt. This can result in volatile earnings as a result of the additional interest expenses.
Total debt to total assets
A loan to value ratio shows the extent to which the business borrows to finance its operations.
• Total debt to total assets = total debt ÷ total assets
Interest coverage ratio
The interest coverage ratio determines how easily a business can pay interest on outstanding debt.
• The interest coverage ratio is calculated by dividing a business’s earnings before interest and taxes (EBIT) of one period by the business’s interest expenses of the same period.
• Interest cover ratio = profit before interest ÷ interest expenses
5. Turnover (activity or efficiency) ratios
Efficiency analysis helps understand how well a business is utilising its resources or capital. Working capital is always significant from the perspective of lenders or creditors: can the business meet its short-term obligations, such as paying suppliers’ bills?
Accounts receivable turnover ratio
The accounts receivable turnover shows how efficient you are at collecting your debts (receivables); that is, it calculates the number of times receivables are collected during the period.
• Accounts receivable turnover = sales revenue ÷ accounts receivable
• A high ratio means that you are good at collecting debts from your customers and a low ratio means that a lot of your customers still owe you for your goods or services.
Accounts payable turnover ratio
The accounts payable turnover ratio shows how efficient you are at settling your debts.
• Accounts payable turnover = cost of goods sold ÷ accounts payable
• A high ratio means that you are paying your debts on time. On the other hand, a low ratio means that you should look at your cash flow.
Inventory turnover ratio
The inventory turnover ratio measures how efficient you are at turning over your stock. It calculates the number of times inventory turns over during a period to determine whether your inventory levels are too high with respect to your sales.
• Stock or inventory turnover = cost of goods sold ÷ (0.5 x (opening inventory + closing inventory))
• You want your stock turnover to be high because that means that you are selling more products.
Inventory days, receivable days or days payable
These represent the times needed to generate cash from inventories, receive cash from trade receivables or pay trade payables, which are useful for analysing liquidity.
• Inventory days outstanding = (average inventories ÷ COGS) x 365 or 365 ÷ inventory turnover
This ratio gives the number of days an item is held as inventory before it is sold. A lower ratio indicates an efficient inventory management system for the business.
• Accounts receivable days (or debtor days) = (receivables ÷ credit sales or sales revenue) x 365 or 365 ÷ accounts receivable turnover
This helps a business understand whether its debtors are enjoying excessive credit. A higher ratio should be investigated for problems with debt collection or the financial position of major customers.
• Days payable outstanding (or creditor days) = (payables ÷ credit purchases) x 365
This helps a business understand whether it is taking full advantage of its available trade credit.
Cash conversion cycle
The cash conversion cycle indicates the length of time, in days, it takes for a business to convert resource inputs into cash flows. The longer the cash conversion cycle, the higher the working capital requirement will be.
• Cash conversion cycle = (accounts receivable days + inventory days outstanding) – days payable outstanding