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What are ratios and what are they used for?
Ratios are measurement mechanisms that allow you to quickly see how well specific parts of your business are performing. One very simple and fun way of thinking about ratios is with your fridge.
Imagine that your share house with roommates and luckily, one of your roommates is a chef who prepares all the meals for his roommates each week. You want to know if this week he’s likely to prepare most vegetarian dishes or more meat dishes. A quick scan of the fridge will help you. If you note that:
Week 1: 2 cuts of meat and 5 vegetable items (Ratio of meat to vegetable is 0.28).
Week 2: 1 cut of meat and 10 vegetable items (Ratio of meat of vegetable is 0.09)
Week 3: 1 cut of meat and 11 vegetable items (Ratio of meat to vegetable is 0.08)
So these ratios will give you information about your meal (even before it gas happened) that your meals are becoming more vegetable based. This information can help you make decisions such as eating out if you’re a meat lover.
While simplistic, can you see how the quick scan of the fridge to compare meat and vegetables is like what a business ratio is? A ratio compares parts of your finances to help give you information about what your business looks like or is going to look like and helps you make decisions.
So… here are some common ratios used to measure business performance along with a description of how they are calculated and what they mean.
| Financial Ratio | What they Do / Description of Ratio | Calculation Method |
|---|---|---|
| Current Ratio | Whether or not the business can pay its debts that fall due in the next 12 months. The higher this is, the better the company’s position to pay its debts. E.g. if the business can only cover it’s debt once, it may rethink borrowing more funds. | Current Assets divided by Current Liabilities |
| Gross Profit % | This ratio calculates much profit margin you make on your sales. E.g. is it 4%, 20%, 80%. For example, if it’s low and you’re not making enough, you could perhaps look at increasing your price or reducing the cost of your supplies. | Gross Profit divided by Net Sales |
| Debt to Equity Ratio | Equity is your net assets (assets less liabilities). This ratio shows you how much of the business you own compared to how much you borrow. A higher debt to equity ratio means that you own less value as you’ll need to pay back debt, whereas a lower debt to equity ratio means that you “own” more of the value of the business. | Total debt divided by Total Equity |
| Working Capital to Total Assets % | This ratio shows how easily your business can pay its bills. If you have more working capital compared to your total assets (higher percentages) you have more “free flow cash” to play around with compared to if you have a lower net working capital. | Net working capital divided by total assets |
| Debt Ratio | The debt ratio shows you your debt levels compared to your total assets. E.g. if you have a ratio of 1 such as $1M in total assets and $1M in debt. You don’t own anything, because if you can’t pay that debt, you’d have to liquidate your $1M assets to pay your $1M in debt (assuming you don’t have sales fees etc…). You want to have the right level of debt where you can service it while using that debt to generate revenue. | Debt divided by total assets |
| Net Profit on Sales % | This ratio shows how efficient your business is operating. For example, if your earnings after tax is still a large portion of your net sales, it means you expenses are being minimized, however, if earnings after tax is a small proportion of your net sales, it’s likely there’s an expense or a few expenses eating at your profit line. | Earnings after tax divided by Net Sales |
| Current Liabilities to Net Worth | Again, another ratio that measures your business’ ability to pay its debts. This ratio measures what you owe within the next 12 months compared to how much your business is worth. A lower value means that your net worth can cover your debts, while a larger number for this ratio may indicate some difficulty in paying its debts. | Current Liabilities divided by Tangible Net Worth |
| Fixed Assets to Net Worth Ratio | Shows how much of the business’ assets are frozen in the form of fixed assets (which can’t easily be sold off quickly). This ratio shows how ‘solvent’ your business is, that means, in tough times, how easy it is for your company to access cash. If you’ve got a lot of fixed assets compared to your tangible net worth, it could raise issues of solvency. | Fixed Assets divided by Tangible Net Worth |
Can you see how ratios can give you a quick snapshot of how things are going? Monitor your ratios often to get a better picture of how your business is going financial wise.
Next: Part 8 - End of Year Reports & Budgeting