Important Accounting Ratios

Accounting Ratios > Important Equations in Accounting

There is no easy way of telling how successful your business is unless you set yourself targets and track your progress against these. By measuring performance, against industry standards and your own benchmarks you track the correct information which then allows you to understand what you need to improve in order to meet the goals.

In accounting, the term ‘Ratio Analysis’ is used to measure performance. The purpose of this is to not only track your current performance against previous years, but to also compare against the competition. By monitoring and identifying issues which can be resolved, this can aid with future decision making too.

There are a few limitations of this Ratio Analysis method:

1. It is reliant upon historic data, so is not current.
2. It doesn’t take into account external factors, such as a recession or pandemic.
3. It does not consider the human element within a business.
4. It can only be used for comparison with other firms of the same size and type.
5. It may be hard to compare with other businesses that don’t share their information.

We have compiled a list of the top ratios which you will find useful for your business, and you may well be using some of these already to track your progress.

Cash Flow To Debt

Cash Flow to Debt Ratio = (Net Income + Depreciation) / Total Debt

Most small businesses will be making money every month, but often still have cash flow problems. This usually occurs when lots of their extra cash is going towards repaying a debt. The issue with debt is that it often doesn’t materialise as a liquidity problem until it is due to be paid. If you are not regularly making repayments, that deadline can come round very quickly and you may not have the cash to repay it all.

That is why cash flow to debt ratio is so important, so that you can keep an eye on cash flow. The closer you get to the end of your loan, the higher your liquidity should be.

Net Profit Margin

Net Profit Margin = (Total Revenue - Total Expenses) / Total Revenue

Net profit margin is the percentage of your revenue left after you have deducted all of your operating expenses, interest and taxes. It gives a good indication of how well you are managing costs, and converting revenue into profits. The net profit margin measures how much profit remains from each pound in sales.

A poor net profit margin is often a sign that a business is not financially stable. It could be linked to a number of factors from poor conversions, or lack of customer retention and acquisition, due to a lack of time spent training customer service teams, or too much expenditure on operating expenses. The higher your net profit margin, the better for your earnings per share will be.

Gross Margin Ratio

Gross Margin Ratio = (Sales - Cost of Goods Sold) / Total Sales

This formula is more targeted to product-based businesses rather than sales-based businesses. It basically means how much money you have left to pay for added expenses (such as marketing), once you have paid for the raw materials or cost of goods sols. The higher your gross margin, the more money you have to pay for these necessary business expenses.

Quick Ratio

Quick Ratio = (Cash + Marketable Securities + Net Accounts Receivable) / Current Liabilities

This ratio is a good calculation for businesses with current liabilities, for example accounts payable, short-term loans, payroll taxes payable, income taxes payable and credit card debt. The ratio calculates whether or not you have enough current assets in order to cover your current liabilities. So would you be able to keep your business afloat if we were faced with a pandemic, for example? If your quick ratio is less than 1, your debts are greater than your assets.

Accounts Receivable Turnover

Accounts Receivable Turnover = (Total A/R Outstanding / Total Sales) x Number of Days

This ratio is more commonly known as Days Sales Outstanding (DSO), and it measures how good your company is at being paid by suppliers or customers. Cash flow is important within any business, and being paid quickly can really help to alleviate some of this stress. We can increase this by using a cost effective piece of software, if this is holding your business back we'd be happy to help you.

Inventory Turnover Ratio

Inventory Turnover Ratio = Cost of Goods Sold / Average Inventory

This ratio is, as you have probably guessed, ideal for businesses that carry inventory (or stock). It tells you how many times inventory was converted to sales within a certain time period. A high inventory turnover ratio means that you are turning over your inventory on a frequent basis. This is quite common for companies that sell perishable goods, such as food.

Investors and creditors both tend to use this ratio as it is often marked as collateral for loans. The inventory is often one of the biggest assets on a retailer’s balance sheet, so if this is unable to be sold then the company is fairly worthless.

Sales Per Employee

Sales Per Employee = Annual Revenue / Number of Employees

This ratio shows you how expensive your business is to run, and also how efficient (or not) your staff may be. As your business grows and you start to hire more employees, this is a good metric to keep an eye on. A higher sales-per-employee ratio indicates that the company can operate on low overhead costs, and therefore do more with fewer employees, which often translates into healthy profits.

Best Way To Use Financial Ratios

Financial ratios show a small insight into how your company is performing financially within a specific period of time. If you are wanting to get a truer indication, you are better looking at trends over a longer period of time. The easiest way to do this is to create a spreadsheet and record every ratio you calculate. Every quarter should be a good place to start with this.

If you would like any help with any of these ratios, or would like us to go into more detail about anything we have mentioned please feel free to contact us.