Analysing the financial performance and position of your business

Analysing the financial performance and position of your business

What do the numbers mean?

 

Financial focus area Ratio How is the ratio calculated? What does the ratio mean?
1 Key liquidity ratios

 

Liquidity ratios measure your company’s ability to meet its short term financial obligations as they fall due.

Current ratio Current ratio = Current Assets/ Current Liabilities To what extent do your current assets exceed your current liabilities.

Is your business able to pay its short term obligations as they fall due?

The current ratio is the most common measure of liquidity.

Quick ratio Quick ratio = (Current Assets – Inventory) – Current Liabilities The quick ratio gives you an indication of how well your company can pay off its short term liabilities as they fall due.

It is very similar to the current ratio except that inventories are subtracted from current assets.

The difference between the current ratio and the quick ratio is that the quick ratio only takes into consideration your most liquid current assets in the computation.

The quick ratio is also known as the acid test ratio.

2 Key financial leverage ratios

 

Is your company highly geared/ leveraged? To what extent does your business depend on borrowed money?

Leverage ratios measure the amount of financing from equity and debt holders. Debt ratio = Debt/ Assets The debt-asset ratio is also known as the debt ratio.

It measures that relative proportions of debt and equity funds used to finance the firm’s assets.

Debt/ Equity ratio This ratio compares your entity’s total debt to total equity. It shows the percentage of your company’s financing that comes from debt providers in relation to what you have invested in your business.

The higher the amount of debt financing relative to equity. financing, the more leveraged your company is. A company that is highly leveraged has high liabilities.

Essentially, if the gearing is too high, your business might not be able to service its debts.

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Key profitability ratios

 

How well is your company performing?

Gross Profit Margin Gross Profit Margin = Gross Profit/ Sales x 100 This is the percentage by which gross profits exceed production costs.

The computation helps you understand how much your business is earning, taking into consideration the cost of sales.

Net Profit Margin Net Profit Margin = Net Profit/ Sales x 100 This shows you how much of your sales are translated into profit. Net profit margin measures the ability of the firm to generate profit out of sales made.
Return on Capital Employed (ROCE) Operating profit/ capital employed ROCE measures the profitability of your company.

ROCE helps you to identify whether changes in the ratio are being caused by changes in the level of sales generated from the asset base of your business or by the change in the profit margin.

4 Key efficiency ratios  

 

Efficiency ratios measure how efficient your company is in utilising assets to generate income.

 

How efficient is your company at selling its products?

Inventory turnover Inventory turnover – Cost of Goods Sold/ Average Inventory This shows the frequency by which the business inventory is sold and replaced over a period of time.
Receivable turnover (Beginning Accounts Receivable + Ending Accounts Receivable)/2 Do you sell your products on credit? The receivable turnover days’ measures how quickly your business recovers the outstanding receivable balances from its consumers.

It essentially looks at how effective your company is at extending credit to your customers and how well it collects it.