UK: Key Financial Management Ratios

Last Updated: 13 September 2012

Want to know how your company is really doing? If so, looking at your gross sales and revenues is not enough. The secret is to look beyond the numbers and pay close attention to the relationships between the numbers. This White Paper tells you all about these relationships and what they can reveal about your business.

Ratios – the real performance indicators

In themselves, the raw numbers on your balance sheet, income statement and cash flow statement have limited value. Of far greater value, when it comes to evaluating your company's financial performance and making critical management decisions, are certain ratios that you can extract from these documents.

When tracked and measured on a regular basis, these key financial ratios allow you to:

  • get a more accurate reading of your company's financial performance
  • compare performance against the previous year, the current budget and your industry as a whole
  • establish benchmarks to see where you are going and how you are doing.

The secret to effective financial management lies in knowing which ratios to track and what they tell you about the state of your business.

Too many CEOs look at gross sales and revenues on the income statement and nothing else. If sales look good, they figure everything else must be in order. In reality, you can have healthy sales growth and still be headed for financial disaster. The only way to know that is to pay attention to the ratios that tell you what's really going on in the business.

These ratios can be divided into three categories:

  1. Balance sheet ratios
  2. Profit and loss ratios
  3. Key operating ratios.

1. Balance sheet ratios

The balance sheet gives the truest picture of the overall health of the business. It acts as a snapshot, telling you where the business stands at a given point in time. Unlike the profit and loss (income) statement, which gives a historical record that never changes, the balance sheet is a living, breathing document that changes on a daily basis.

The three most important balance sheet ratios are as follows.

  • Current ratio measures whether you have enough current assets (defined as anything that can be turned into cash within a year) to meet your current liabilities.

Current ratio formula: Current assets divided by current liabilities

  • Quick ratio measures the company's ability to meet financial obligations using only liquid current assets: cash or assets that can be turned into cash within 90 days. (The quick ratio does not include inventory because, if you have to liquidate, you never get full value for inventory.)

Quick ratio formula: (Current assets minus inventory) divided by current liabilities

  • Debt-to-equity ratio measures how much of the company is financed by borrowing versus owner equity. This ratio plays a major role in determining how much you can borrow and at what interest rate.

Debt-to-equity ratio formula: Net worth divided by total liabilities

Uses of balance sheet ratios

Balance sheet ratios are crucial because they measure the amount of risk in the business. The current and quick ratios (also known as liquidity ratios) measure the company's ability to survive a short-term financial crisis. The debt-to-equity ratio (also known as the safety ratio) measures the company's ability to survive over the long term.

If sales and revenues continue to climb while these three measures show a decline – a frequent scenario in fast-growth companies – you have a real problem on your hands.

2. Profit and loss ratios

The profit and loss (P&L) statement focuses on revenues, expenses and net income (or loss) over a defined period of time. It measures the company's ability to turn sales and revenues into profits – a key ingredient for long-term success.

The most important P&L ratios include the following.

  • Gross profit ratio measures how much money you bring in after subtracting the costs of goods sold.

Gross profit ratio formula: Revenues minus cost of goods sold

  • Gross margin ratio measures how much it costs to obtain sales.

Gross margin ratio formula:Net sales minus cost of goods sold

  • Net operating profit ratio represents how much money you have left over, before interest, depreciation and taxes, after all expenses are taken out. Some people also refer to this as EBITDA (earnings before interest, taxes, depreciation and amortisation).

Net operating profit ratio formula:Gross margin minus selling, general and administrative expenses

  • Net profit ratio measures how much money is left over after all expenses are taken out.

Net profit ratio formula: (Net operating profit plus income) minus (other expenses plus taxes)

Uses of profit and loss ratios

In our opinion, gross margin (and its relationship to expenses) is the most important P&L ratio. You need to pay attention to all of the P&L ratios, because they affect your profitability. But if you lose the gross margin battle, you can do a lot of other things right and still go out of business.

You can have a high gross margin and still have expenses higher than your gross margin. The key is the relationship of gross margin to expenses.

3. Key operating ratios

The following ratios combine information from the balance sheet and income statement to provide a more sophisticated picture of what is happening in the business.

  • Gross profit ratio measures the percentage of every £ of sales that becomes gross profit. For example, a gross profit ratio of 40% means that you earn 40 pence at the gross profit level for every £ of sales.

Gross profit ratio formula: Gross profit divided by sales

  • Pre-tax profit ratio measures how much you make at the net profit level for every £ of sales you generate.

Pre-tax profit ratio formula: Pre-tax profit divided by sales

  • Sales-to-assets ratio measures the amount of sales generated for every £ of assets employed in the business. For example, a sales-to-assets ratio of 2.5 means that you generate £2.50 in sales for every £ of assets in the business.

Sales-to-assets ratio formula: Total assets divided by sales

  • Return on assets ratio measures how much profit you generate for every £ in assets.

Return on assets ratio formula: Pre-tax profits divided by total assets

  • Return on equity ratio measures the return on every £ you have invested in the business.

Return on equity ratio formula: Pre-tax profit divided by equity

  • Inventory turnover ratio measures how many times a year you turn over your inventory. If you use sales cost, you must also use inventory cost. If you use selling price (which retail businesses typically do), you must also use inventory selling price. You can use either cost or selling price, so long as you are consistent.

Inventory turnover ratio formula: Sales divided by average inventory

  • Days in inventory ratio measures how long, on average, it takes to turn over your inventory.

Days in inventory ratio formula: Inventory turnover divided by 365 days

  • Accounts receivable turnover ratio measures how many times a year you collect your accounts receivable.

Accounts receivable turnover ratio formula: Sales divided by accounts receivable

  • Collection period ratio measures how often, on average, you collect your accounts receivable.

Collection period ratio formula: Accounts receivable turnover divided by 365 days

  • Accounts payable turnover ratio measures how many times a year you pay your accounts payable. As with the inventory turnover ratio, you can use cost or selling price, as long as you use the same factor on both sides of the equation.

Accounts payable turnover ratio formula: Cost of goods sold divided by average accounts payable

  • Payable period ratio measures, on average, how often you pay your accounts payable.

Payable period ratio formula: Accounts payable turnover divided by 365 days

Uses of key operating ratios

Why bother tracking these seemingly arcane ratios? Because they tell you how efficient your company is at generating and using cash. More important, they tell you what's happening to your cash flow.

The raw numbers on the monthly cash flow statement are important because they tell you how much cash you have on hand and how the cash got used last month. But these operating ratios tell you what's going to happen to your cash flow in the near future. If you're going to run out of cash, you need to know while you still have time to do something about it.

How to get better ratios

The whole purpose of studying ratios is to make them better. To improve your ratios, we recommend the following.

To improve your balance sheet ratios:

  • Speed up inventory turnover. This improves cash flow and reduces risk, because inventory always carries a certain amount of obsolescence risk.
  • Consider leasing rather than purchasing equipment. In many cases leasing is more cost effective, especially if the technology is changing quickly in your industry.
  • Reduce the time it takes to collect receivables. This is one of the easiest ways to increase cash flow, if you pay attention to it.
  • Get increased day terms. If you can extend your payables to 60 or 90 days without increasing the cost of goods, in essence you get your vendors to finance the business. However, get your price first and then go for additional days.

To improve your profit and loss ratios:

  • Leverage sales over fixed costs. Strive to get more effective and efficient so that you can improve sales without increasing costs. We recommend the following:
    • Sell more to existing customers.
    • Work on closing skills.
    • Sell at the right level. Don't waste time trying to sell to people who can't make the decision.
    • Identify segments of your business where more potential exists.
    • Review how you incentivise your sales mix. Make sure the compensation programme for your sales team is in alignment with the best interests of the company.
    • Pay sales people for receivables that get collected, not just for making sales.
    • Hold the sales team accountable for desired results.
  • Increase gross margins. We suggest attacking margins from three angles:
  1. Cost. Constantly work to lower your cost of goods sold.
  2. Value. Are you getting paid for all the value you provide customers?
  3. Velocity. The faster you move things through the business, the faster you collect cash. Focus on increasing velocity to generate more cash and improve margins.
  • Review pricing opportunities. Consider giving lower costs in rebate form after customers achieve certain purchasing levels. This allows you to keep the cash flow while forcing customers to buy more in order to receive the discount.
  • Use zero-based budgeting. Don't let your people automatically submit budget increases every year. Instead, have them start with a blank piece of paper and cost-justify everything they do.
  • Compensate people for productivity rather than time. Have some element in your compensation programme that is tied to productivity. When you pay for time, you get time, which requires more supervision and increases costs.
  • Outsource when it's economically advantageous. Study your non-core processes and look for things that other companies can do more cheaply. Conversely, there may be things you are so good at that you can do them for other companies.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

To print this article, all you need is to be registered on Mondaq.com.

Click to Login as an existing user or Register so you can print this article.

 
In association with
Related Topics
 
Related Articles
 
Related Video
Up-coming Events Search
Tools
Print
Font Size:
Translation
Channels
Mondaq on Twitter
 
Mondaq Free Registration
Gain access to Mondaq global archive of over 375,000 articles covering 200 countries with a personalised News Alert and automatic login on this device.
Mondaq News Alert (some suggested topics and region)
Select Topics
Registration (please scroll down to set your data preferences)

Mondaq Ltd requires you to register and provide information that personally identifies you, including your content preferences, for three primary purposes (full details of Mondaq’s use of your personal data can be found in our Privacy and Cookies Notice):

  • To allow you to personalize the Mondaq websites you are visiting to show content ("Content") relevant to your interests.
  • To enable features such as password reminder, news alerts, email a colleague, and linking from Mondaq (and its affiliate sites) to your website.
  • To produce demographic feedback for our content providers ("Contributors") who contribute Content for free for your use.

Mondaq hopes that our registered users will support us in maintaining our free to view business model by consenting to our use of your personal data as described below.

Mondaq has a "free to view" business model. Our services are paid for by Contributors in exchange for Mondaq providing them with access to information about who accesses their content. Once personal data is transferred to our Contributors they become a data controller of this personal data. They use it to measure the response that their articles are receiving, as a form of market research. They may also use it to provide Mondaq users with information about their products and services.

Details of each Contributor to which your personal data will be transferred is clearly stated within the Content that you access. For full details of how this Contributor will use your personal data, you should review the Contributor’s own Privacy Notice.

Please indicate your preference below:

Yes, I am happy to support Mondaq in maintaining its free to view business model by agreeing to allow Mondaq to share my personal data with Contributors whose Content I access
No, I do not want Mondaq to share my personal data with Contributors

Also please let us know whether you are happy to receive communications promoting products and services offered by Mondaq:

Yes, I am happy to received promotional communications from Mondaq
No, please do not send me promotional communications from Mondaq
Terms & Conditions

Mondaq.com (the Website) is owned and managed by Mondaq Ltd (Mondaq). Mondaq grants you a non-exclusive, revocable licence to access the Website and associated services, such as the Mondaq News Alerts (Services), subject to and in consideration of your compliance with the following terms and conditions of use (Terms). Your use of the Website and/or Services constitutes your agreement to the Terms. Mondaq may terminate your use of the Website and Services if you are in breach of these Terms or if Mondaq decides to terminate the licence granted hereunder for any reason whatsoever.

Use of www.mondaq.com

To Use Mondaq.com you must be: eighteen (18) years old or over; legally capable of entering into binding contracts; and not in any way prohibited by the applicable law to enter into these Terms in the jurisdiction which you are currently located.

You may use the Website as an unregistered user, however, you are required to register as a user if you wish to read the full text of the Content or to receive the Services.

You may not modify, publish, transmit, transfer or sell, reproduce, create derivative works from, distribute, perform, link, display, or in any way exploit any of the Content, in whole or in part, except as expressly permitted in these Terms or with the prior written consent of Mondaq. You may not use electronic or other means to extract details or information from the Content. Nor shall you extract information about users or Contributors in order to offer them any services or products.

In your use of the Website and/or Services you shall: comply with all applicable laws, regulations, directives and legislations which apply to your Use of the Website and/or Services in whatever country you are physically located including without limitation any and all consumer law, export control laws and regulations; provide to us true, correct and accurate information and promptly inform us in the event that any information that you have provided to us changes or becomes inaccurate; notify Mondaq immediately of any circumstances where you have reason to believe that any Intellectual Property Rights or any other rights of any third party may have been infringed; co-operate with reasonable security or other checks or requests for information made by Mondaq from time to time; and at all times be fully liable for the breach of any of these Terms by a third party using your login details to access the Website and/or Services

however, you shall not: do anything likely to impair, interfere with or damage or cause harm or distress to any persons, or the network; do anything that will infringe any Intellectual Property Rights or other rights of Mondaq or any third party; or use the Website, Services and/or Content otherwise than in accordance with these Terms; use any trade marks or service marks of Mondaq or the Contributors, or do anything which may be seen to take unfair advantage of the reputation and goodwill of Mondaq or the Contributors, or the Website, Services and/or Content.

Mondaq reserves the right, in its sole discretion, to take any action that it deems necessary and appropriate in the event it considers that there is a breach or threatened breach of the Terms.

Mondaq’s Rights and Obligations

Unless otherwise expressly set out to the contrary, nothing in these Terms shall serve to transfer from Mondaq to you, any Intellectual Property Rights owned by and/or licensed to Mondaq and all rights, title and interest in and to such Intellectual Property Rights will remain exclusively with Mondaq and/or its licensors.

Mondaq shall use its reasonable endeavours to make the Website and Services available to you at all times, but we cannot guarantee an uninterrupted and fault free service.

Mondaq reserves the right to make changes to the services and/or the Website or part thereof, from time to time, and we may add, remove, modify and/or vary any elements of features and functionalities of the Website or the services.

Mondaq also reserves the right from time to time to monitor your Use of the Website and/or services.

Disclaimer

The Content is general information only. It is not intended to constitute legal advice or seek to be the complete and comprehensive statement of the law, nor is it intended to address your specific requirements or provide advice on which reliance should be placed. Mondaq and/or its Contributors and other suppliers make no representations about the suitability of the information contained in the Content for any purpose. All Content provided "as is" without warranty of any kind. Mondaq and/or its Contributors and other suppliers hereby exclude and disclaim all representations, warranties or guarantees with regard to the Content, including all implied warranties and conditions of merchantability, fitness for a particular purpose, title and non-infringement. To the maximum extent permitted by law, Mondaq expressly excludes all representations, warranties, obligations, and liabilities arising out of or in connection with all Content. In no event shall Mondaq and/or its respective suppliers be liable for any special, indirect or consequential damages or any damages whatsoever resulting from loss of use, data or profits, whether in an action of contract, negligence or other tortious action, arising out of or in connection with the use of the Content or performance of Mondaq’s Services.

General

Mondaq may alter or amend these Terms by amending them on the Website. By continuing to Use the Services and/or the Website after such amendment, you will be deemed to have accepted any amendment to these Terms.

These Terms shall be governed by and construed in accordance with the laws of England and Wales and you irrevocably submit to the exclusive jurisdiction of the courts of England and Wales to settle any dispute which may arise out of or in connection with these Terms. If you live outside the United Kingdom, English law shall apply only to the extent that English law shall not deprive you of any legal protection accorded in accordance with the law of the place where you are habitually resident ("Local Law"). In the event English law deprives you of any legal protection which is accorded to you under Local Law, then these terms shall be governed by Local Law and any dispute or claim arising out of or in connection with these Terms shall be subject to the non-exclusive jurisdiction of the courts where you are habitually resident.

You may print and keep a copy of these Terms, which form the entire agreement between you and Mondaq and supersede any other communications or advertising in respect of the Service and/or the Website.

No delay in exercising or non-exercise by you and/or Mondaq of any of its rights under or in connection with these Terms shall operate as a waiver or release of each of your or Mondaq’s right. Rather, any such waiver or release must be specifically granted in writing signed by the party granting it.

If any part of these Terms is held unenforceable, that part shall be enforced to the maximum extent permissible so as to give effect to the intent of the parties, and the Terms shall continue in full force and effect.

Mondaq shall not incur any liability to you on account of any loss or damage resulting from any delay or failure to perform all or any part of these Terms if such delay or failure is caused, in whole or in part, by events, occurrences, or causes beyond the control of Mondaq. Such events, occurrences or causes will include, without limitation, acts of God, strikes, lockouts, server and network failure, riots, acts of war, earthquakes, fire and explosions.

By clicking Register you state you have read and agree to our Terms and Conditions