Why it’s important to analyse your finances


You can use financial ratios and calculations to monitor the health of your business. These help you to identify potential problems early on and make changes.

Ratios vary from industry to industry. Compare your ratio to a benchmark value for similar industries to get a realistic idea of how your business is going.

Below are some of the main ratios and calculations to help you monitor your business. If you aren't confident working these out, check the figures with your accountant or talk to a business adviser.

Sales calculations


Break-even analysis

This break-even formula tells you how much you need to sell to break even. Above your break-even point your business will start making a profit. Analysing your break-even point helps you set sales goals and better manage your inventory.

Break-even point = total fixed costs/(average price of each product/service – average cost of each product/service to make or deliver).

Margin

A margin shows you how much of each sale is profit (as a percentage). It helps you make budgeting and pricing decisions. Lenders and investors use your margin to decide if you're a good candidate for finance.

Margin = ((sales – cost of goods sold)/sales) x 100

Mark up

A mark up is the percentage you add to the cost price of goods, to get your selling price. Use mark up to choose a price that isn’t too high or low for your products or services. When calculating your mark up, it's useful to consider your margin percentage as a starting point.

Mark up = ((sales – cost of goods sold)/cost of goods sold) x 100

Margin versus mark up

These are often confused, but it's important you know the difference. If you confuse mark up and margin, you could seriously undervalue your products or services. You’d risk not making enough profit to cover your costs.

The easiest way to work out the difference is by calculating both figures. The mark up percentage is always higher than the margin.

Example of mark up versus margin

Mark sells a product for $15 which cost him $10 to produce. Mark wants to know what percentage of his product is profit (margin) and what percentage is mark up.

Margin = (($15 - $10)/$15) x 100 = 33%

Mark up = (($15 - $10)/$10) x 100 = 50%

So, while Mark has a mark up of 50%, his margin (profit) is only 33%.

Note: in this simplified example we use gross profit figures. This doesn’t account for the overall expenses of the business.

Mark down

A mark down is the percentage discount on a product. You’d generally use a markdown in a promotion or sale to:

  • attract sales, or
  • move extra or discontinued stock

Mark down price = original price – (original price x markdown)

Example of markdown price

Mary wants to shift her least profitable stock. She decides to sell her goods at half price.

Mark down price = $20 – ($20 x 50%) = $10.

Commonly used financial ratios


The most common types of ratios are:

  • profitability ratios – to measure business performance
  • liquidity ratios – to work out how solvent your business is
  • financing ratios – to evaluate financing and investment
  • turnover (efficiency) – to analyse stock turnover and cash flow

Profit ratios


Gross profit margin ratio

This shows you the proportion of profit for every sales dollar before expenses. An acceptable gross profit margin ratio varies from industry to industry. In general, the higher the margin the better.

Gross profit margin = gross profit/sales : 1.0

Net profit margin ratio

This shows the proportion of profit for every sales dollar after expenses. An acceptable net profit margin ratio varies from industry to industry, but generally, the higher the margin the better.

Net profit margin = net profit/sales : 1.0

Gross profit versus net profit

You can easily see the difference between your gross profit and net profit on your profit and loss statement. Your gross profit is your sales minus your cost of goods sold, but does not factor in your business operating expenses. Net profit is a better indication of profit, as it factors in your operating expenses.

Example of gross profit versus net profit

During May, Jeff sells 30 products at $15 each. Each product costs him $10 to produce. His overall operating costs for the month are $80. Jeff's gross and net profits for the month are as follows:

Sales = $450, cost of goods = $300

Gross profit = sales – cost of goods = $450 - $300 = $150

Net profit = gross profit - operating costs = $150 - $80 = $70

Return on investment (ROI)

ROI shows how efficient your business is at generating profit from the original investment (equity) from owners or shareholders. Lenders will also use your ROI to help them determine the financial strength of your business.

ROI = net profit/owner's equity

Liquidity ratios


Current ratio or working capital ratio

The current ratio works out your business' liquidity. This is how quickly you can convert assets into cash to pay your current bills or liabilities. This ratio is a good measure of the financial strength of your business.

For example, a ratio of 1:1 means you have no working capital left after paying bills. So generally, the higher the ratio, the better off your business will be. Lenders will also use your current ratio to help them determine your capacity to repay a potential loan.

Current ratio = current assets/current liabilities : 1.0

Quick ratio

The quick ratio or acid test ratio is similar to current ratio except it excludes inventory (which can be slow moving). This is a much more conservative measure of liquidity. A ratio of 1:1 means you have no working capital left after paying bills. So generally, the higher the ratio, the better off your business will be. Lenders will use your quick ratio to help them determine your capacity to repay a loan.

Quick ratio = (current assets – inventory)/current liabilities : 1.0

Financing ratios


Debt to equity ratio

This ratio shows you what type of financing your business is more reliant on – debt or equity. A ratio of 1:1 means you have an equal proportion of debt and equity. In general, you want a mid-to-low level ratio. The higher the ratio, the higher risk your business is to lenders.

Debt to equity ratio = total liabilities/total equity : 1.0

Loan to value ratio

A loan to value ratio (LVR) is the loan amount as a percentage of the market value of the asset you’re buying. It helps lenders work out if they can get the loan amount back if you stop making payments. The percentage lenders accept varies, but the lower the LVR, the better.

LVR = (loan amount/property or asset value) x 100

Turnover (efficiency) ratios


Accounts receivable turnover ratio

This ratio measures how well you collect debts from your customers. A low ratio can mean you need to work more on collecting debts.

Accounts receivable turnover = total sales/accounts receivable : 1.0

Accounts payable turnover ratio

This measures how well you pay your debts. The lower the ratio, the more you need to look at your cash flow.

Accounts payable turnover = cost of goods sold/accounts payable : 1.0

Stock (inventory) turnover ratio

This ratio measures how efficient you’re at turning over your stock. A low ratio suggests your stock is either naturally slow moving, or you need to increase sales so stock spends less time in storage.

Stock or inventory turnover = cost of goods sold/0.5 x (opening inventory + closing inventory) : 1.0

Financial health check tool

The ATO provides a free tool to help you check the financial health of your business.

You’ll need to input your financial figures for at least 3 months. The tool then provides you with a report on your business viability, including the main financial ratios.