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Checking the health of your business print Print

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Your financial figures can quickly tell you how well your business is performing and help you spot trends. This guide discusses some of the common ways of checking the health of your business and gives some indications of what you should be aiming for.

Running an efficient business

How do you know how well your business is doing? It's not much good relying on once-yearly figures from your accountant. These might tell you how well your business performed last year, but what has happened in the months since then?

The key to building a profitable business is to find out what is working and what is not, and then eliminate what's not working. The more quickly and regularly you can do this, the more opportunities you have to correct trends before they might damage your business.

This is a very strong argument for using accounting software and for keeping your books up to date. Accounting software allows you to generate instant reports (daily if necessary) on the state of your business. From this information you can perform some quick spot checks on the health of your business (or often set up the software to do this for you automatically).

The process is called ratio analysis, which sounds technical, but is in fact quite a simple process, usually involving little more than dividing one figure by another to produce a ratio. Some of the key aspects you might be interested in are:

  • How profitable is your business? (Are you making enough margin?)
  • How efficient is your business? (Are you running the business effectively?)
  • How liquid is your business? (Are you solvent? Can you pay your bills?)
  • Has the financial structure of your business changed? (How much do you own, and what's the debt level?)

This guide looks at some of the common ratios used in each category. Note that ratios are relatively meaningless unless you can compare them against some benchmark, such as last year's ratios or industry averages. Your accountant will be able to help you interpret the important ratios for your business and help you set standards to aim for.


Size doesn't matter

One of the great advantages of ratio analysis is that it reduces figures to ratios or percentages. This allows you to compare the efficiency of your business with a much larger (or smaller) business.

 

1. How profitable is your business?

Gross profit margin

This ratio shows whether your average mark-up is sufficient to cover all expenses and show a profit. Simply divide Gross Profit by Annual Sales and multiply by 100 to get a percentage. For example:

Gross profit:

$40,000

Annual Sales:

$200,000

Ratio: $40,000 divided by $200,000 = 0.2 x 100 equals 20%.

You should aim to achieve at least an equal or higher percentage than similar businesses in your industry.

A low margin - especially in relation to industry norms - could indicate you are under pricing. A high margin could indicate overpricing if business is slow and profits are weak.

We also have a Gross Margin Profit calculator that you can download.


Return on equity

This ratio shows if you're receiving a satisfactory return on your investment in your business. Simply divide the Net Profit after tax by Owner's Equity. (Note: You'll find the Owner's Equity figure on the Balance Sheet. It represents how much money you've invested to start or buy the business, plus any profit left in over the years). For example:

Net profit:

$10,000

Owner's Equity:

$100,000

Ratio: $10,000 divided by $100,000 = 0.10 x 100, or 10%

Your aim is to get at least as much return on the money you've invested in the business as interest you could otherwise earn at the bank or a safe investment. Many would aim much higher than this and regard 20% to 25% as a minimum acceptable return on their investment, given the level of risk associated with small business.

     

2. How efficient is your business?

Rate of stock turn

Discover your rate of stock turn by dividing the Cost of Goods Sold (CoGS) by Average Stock. For example:

Cost of Goods Sold:

$100,000

Average Stock:

$20,000

(Note: CoGS = Opening Stock plus Purchases less Closing Stock. Average Stock = Opening Stock plus Closing Stock divided by 2). Ratio: $100,000 divided by $20,000 = 5 (showing that you're turning your stock over 5 times per year).

This figure will vary according to the particular business. Ask your accountant for typical figures for your industry, so you have a benchmark to aim for or to better. Aim for the highest stock turn possible while still maintaining adequate levels of stock. A slow stock turn could mean overstocking or that you hold high levels of out-of-date or poorly selling stock.


Debtor days

This ratio shows the efficiency with which your business is collecting debt on average, by comparing the result with the credit terms you allow.

You discover this ratio by dividing Debtors by Annual Credit (invoiced, not cash) Sales. For example:

Debtors:

$35,000

Annual Invoiced Sales:

$252,000

Ratio: $35,000 divided by $252,000 x 365 days = an average of 51 days to collect debt. Aim to collect all debt in less than your normal credit terms. For example, normal credit terms, (20th of month following invoice) gives debtors around 40 days on average to pay, so there's definitely room for improvement!

The more efficiently you collect debt, the better your cashflow situation is likely to be. If this ratio is deteriorating it shows you're not managing your debtors efficiently and people loaning money to you will take note. Remember, you're in business to make a profit, not to finance other businesses with 'cheap' money by letting them get away with not paying you.


Creditor days

How quickly do you pay creditors? Discover this average by dividing Creditors (Accounts Payable) by Purchases and then multiplying by 365 (days in the year). Note: you can get a more useful figure by ignoring such items as advertising, electricity and phone costs and instead concentrating on your true trade creditors.

For example:

(Trade) Creditors:

$50,000

Purchases:

$250,000

Ratio: $50,000 divided by $250,000 x 365 = 73 days.

This ratio shows how long it takes you on average to pay your creditors. Now compare the result with the average credit terms your business receives from these creditors and also to the previous year's ratios. A longer payment time than average credit terms could mean a shortage of cash in your business and that you're missing out on buying discounts for prompter payment. A deteriorating creditor's payments rate signals business problems or poor cashflow management since you don't have enough money to pay your bills on time.

        

Expenses ratio

Are your expenses increasing out of proportion to any increase in business? Discover this by dividing your Total Expenses by Annual Sales. For example:

Total Expenses:

$40,000

Annual Sales:

$200,000

Ratio: 40,000 divided by 200,000 = 0.2 or 20% (i.e., you incurred $20 of expenses for each $100 of sales). You should look at the expense ratio particularly if your net profit is on a downward trend.

Always aim to keep your expenses as low as possible and under control in relation to previous years.

Even if the business is doing well, a deteriorating expenses ratio can signal that you're letting expenses creep up unnecessarily. In other words, your grip on the reins of the business is slipping. The message is that you can always cut some fat from business expenses, with very pleasing results at your bottom line.

 

3. How liquid is your business?

Current ratio

Can you pay your bills as they fall due? Check your current ratio by dividing Current Assets by Current Liabilities. For example:

Current Assets:

$300,000

Current Liabilities:

$100,000

Ratio: $300,000 divided by $100,000 = 3 (or 300%).

Aim for a ratio of at least 2 to 1 (or 200%), in other words, $2 in assets for every $1 of liabilities, to ensure you're holding adequate funds to meet your short-term commitments. You need greater assets than liabilities at all times. Note: this ratio will depend on the cash cycle of the business, that is, on such factors as stock turn and debtor collection times. Improve these figures and you're likely to improve your current ratio (sometimes called a working capital ratio) as well.


Quick ratio

The quick (liquidity) ratio is an even tougher test than your Current ratio because it leaves out Stock. It measures how much ready money (quick money or liquid assets) you have on hand to pay bills. It's important for businesses with a lot of money tied up in stock, because this money can't always be freed up quickly to pay bills.

Work it out by subtracting the Stock figure from your Current Assets (Cash plus Debtors). Then divide this by Current Liabilities and multiplying by 100 for a percentage. For example:

Current Assets:

=$50,000

(Less Stock of $40,000)

=$10,000

Current Liabilities:

=$12,000

Ratio: $50,000 less $40,000 = $10,000 divided by $12,000 =0.83 x 100 = 83%. In other words, you only have 83% of the ready money you need to pay debts, or 83 cents for each dollar of debt. This ratio signals payment difficulties that could lead to other problems. Aim to have at least 100% or a ratio of 1:1.

                

4. Financial structure of the business

Equity to assets (Ownership ratio)

How much of the business do you actually own? Discover this by dividing Owner's Equity by Total Assets (ignore intangibles such as goodwill). For example:

Owner's Equity:

$100,000

Total Assets (no goodwill):

$200,000

Ratio: $100,000 divided by $200,000 = 0.5 or 50%.

A low ownership ratio means your business may be undercapitalised, which can lead to unacceptable levels of risk, particularly if trading levels decrease, because you have significant levels of debt and borrowings to repay. Your aim should be to ensure that the owner(s) have a satisfactory stake in the business in relation to creditors. Aim for a minimum ownership ratio of 40%. You may find it difficult to borrow money if this ratio drops to the level where the borrower will have more at stake in the business than you do.

 

Summary

These are only a few samples of the many possible ratios available for analysis. Their importance varies from business to business so a good idea is to select no more than five or six of the key ratios that will tell you how your particular business is doing and concentrate on these. Your accountant should be able to help you identify the most important ones for your particular business. (Note that the ratios discussed here also appear under different names).

Ratio analysis can be a very useful way of determining trends in your business and alerting you to dangers before they turn into disasters, allowing you to take timely action.

They are also useful to your lenders, letting them know how well your business is performing. Lenders will, of course, look at other matters as well, such as the nature of your particular industry, whether the profit trends for your industry are increasing or decreasing, and the health of the economy.

 

Resources

Other articles

 

Further information:

To talk to an ANZ Business Specialist:
Call 0800 269 249
Visit anz.co.nz/business
Visit your nearest ANZ branch

     

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