Analyse Your Finances: Financial Ratios
Once your finances are in order, your business can be analysed using a number of key financial ratios and calculations. Financial or benchmarking ratios are useful to help identify potential problems with your business. When a ratio appears outside normal benchmarks, you can easily investigate and help stop any further damage from occurring. Ratios vary greatly from industry to industry, so comparing your ratio to the benchmark ratio for your particular industry will give you a better idea of how your business is tracking.
Below are just some of the key ratios and calculations to help you monitor the different areas of your business. If you aren't confident in working out the calculations below, double check your figures with your accountant or find advice with our advisory services.
The break-even formula helps find the point at which your business will start making a profit. A break-even point analysis can help set sales goals and better manage inventory. The calculation will tell you the total sales dollars or the number of products/services you need to sell to break-even. The break-even formula below represents the break-even point as the number of products/services needed to break even.
Break-even point = Total fixed costs / Average price of each product/service - Average cost of each product/service to make or deliver)
A margin shows you the percentage of each sale that is profit. Your margin is used to determine your business' profitability and can help you make budgeting and pricing decisions. It's also a key calculation lenders and investors use to determine whether you're a good candidate for finance.
Margin = (Sales - Cost of Goods Sold) / Sales * 100
A mark up is the percentage amount added to the cost price of goods, to arrive at a selling price. Your mark up is generally used to select a price for your products/services so that your prices aren't too high or too low. When calculating your mark up, it's useful to take into consideration your margin percentage as a starting point.
Mark up = (Sales - Cost of Goods Sold) / Cost of Goods Sold * 100
Margin vs mark up
These two calculations are often confused and used interchangeably, but it's vital you know the difference. Confusing your mark up and margin figures could result in you seriously undervaluing your products/services and risking not making enough profit to cover all of your costs.
The easiest way of working out the difference is by calculating both figures and putting them side by side. You will notice that the mark up percentage is always higher than the margin.
For example: Mark sells a product for $15 which costs him $10 to produce. Mark wants to know what percentage of his product is profit (margin) and what percentage is mark up. As you can see in the example below, while Mark has a mark up of 50%, his margin or his profit on the product is only 33%.
Margin = ($15 - $10) / $15 * 100 = 33% Mark up = ($15 - $10) / $10 * 100 = 50%
Please note: For the purposes of this simplified example we are using gross profit figures and the overall expenses of the business have not been taken into account.
- Mark down
A mark down is a percentage discount applied to a product. Generally, a markdown is used during a promotion or sale for the purposes of attracting sales and also useful for shifting surplus or discontinued inventory.
Mark down price = Original price – (Original price * Markdown)
For example: Mary wants to shift her least profitable stock and has decided to sell her goods at half price. Here is Mary's calculation:
Mark down price = $20 – ($20 * 50%) = $10
Gross profit margin ratio
A gross profit margin ratio shows the proportion of profit for each sales dollar before expenses have been paid. An acceptable gross profit margin ratio varies from industry to industry but in general the higher the margin the better.
Gross profit margin = Gross Profit / Sales : 1.0
Net profit margin ratio
A net profit margin ratio shows the proportion of profit for each sales dollar after expenses have been paid. 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 vs net profit
The difference between your gross profit and net profit can easily be seen 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 truer indication of your profit, as it factors in both your cost of goods sold and your operating expenses.
For example: For the month of May, Jeff has sold 30 products at $15 each. Each product costs him $10 to produce and his overall operating costs for the month are $80. Jeff's Gross and Net Profits for the month are as follows:
Sales $450 minus Cost of goods sold $300 = Gross Profit $150 minus Operating costs $80 = Net Profit $70
Return on investment (ROI)
ROI shows how efficient your business is at generating profit from the original investment (equity) provided by the owners/shareholders. Lenders will also be interested in your ROI to help them determine the financial strength of your business.
ROI = Net Profit / Owner's Equity
Current ratio/Working capital ratio
The current or working capital ratio works out your business' liquidity — which is how quickly your business can convert assets into cash for the purpose of paying your current bills/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 be interested in your current ratio to help them determine your capacity to repay a potential loan.
Current ratio = Current assets/ Current liabilities : 1.0
The quick ratio or acid test ratio is similar to the current ratio except that it excludes inventory, which can sometimes be slow moving. This ratio provides a much more conservative measure of the liquidity of a 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 be interested in your quick ratio to help them determine your capacity to repay a potential loan.
Quick ratio = (Current assets – Inventory) / Current liabilities : 1.0
Debt to equity ratio
The debt to equity ratio shows you what type of financing your business is more reliant on – debt or equity (private investment). A ratio of 1:1 means you have an equal proportion of both 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 shown as a percentage of the market value of the property or asset that will be purchased. The ratio helps a lender work out if the loan amount can be recouped in the event a loan goes into default. The percentage lenders are willing to accept will vary but the lower the LVR, the better.
LVR = (Loan amount / Property or asset value) * 100
Accounts receivable turnover ratio
This ratio measures your effectiveness at collecting debts from your customers. A low ratio can indicate that you need to do more work to collect your debts.
Accounts receivable turnover = Total sales / Accounts receivable : 1.0
Accounts payable turnover ratio
This ratio measures your effectiveness at paying your debts. The lower the ratio, the more you need to reassess your cash flow situation.
Accounts payable turnover = Cost of goods sold / Accounts payable : 1.0
Stock/Inventory turnover ratio
This ratio measures your effectiveness at turning over your stock. A low ratio can indicate that your stock is either naturally slow moving or that you need to increase your rate of sales so that your stock spends less time in storage.
Stock/Inventory turnover = Cost of goods sold / 0.5 x (Opening inventory + Closing inventory) : 1.0
Finance health check
The Australian Taxation Office (ATO) provides a number of tools to help you determine the financial health of your business including:
- Business viability assessment tool The ATO Business viability assessment tool can help you determine the viability or the financial health of your business. Simply by entering financial figures for a minimum of three months, you'll receive an overview of your business viability in a printable report. The report covers key financial ratios and provides you with an assessment of the financial position and performance of your business.
- Small business benchmark ratios The ATO benchmarks are calculated using financial data from similar businesses in the same industry. Benchmarks are one of the tools the ATO uses to identify a business for audit. These benchmarks are also very useful to use as your own monitoring system. Before you start benchmarking your business against these ratios you need to ensure your turnover is your gross income not your net profit and that your figures are GST exclusive.
What to do...
- Visit the ATO's Business viability assessment tool and Small business benchmarks page for more information on how to calculate the ratios and how your figures compare to similar businesses in your industry.
- Refer to our Glossary of key financial terms for help with financial terminology.
- See how to manage your finances in your state or territory.