The Numbers Story
We all love a good story. For some, it is a love story, for others like crime and others’ actions. The financial numbers in a business also tell a story to the stakeholders. The question now is how do numbers tell a story? Accounting is the language of business and financial ratios help you to read between the lines. To be successful we need to learn from past mistakes to make better decisions. Every business owner must have a basic understanding of the ratios. Your accountant will also be able to assist with the understanding of these ratios. These ratios indicate the core of your company’s health and enable you to plan. It can be used to analyse trends, compare your business to the industry and competitors, and measure your progress towards your objectives.
Financial ratios can also be a Key Performance Indicator (KPI). A variety of financial ratios exist, and you can also develop your own. It is important not to get overwhelmed. You can decide what financial ratios are important to you and the numbers to calculate the ratios are found on the financial statements. Take some time and think about what other KPIs can be of value in your business e.g., website traffic, customer satisfaction, returning clients and sales per employee.
Here is a short list of ratios that will benefit most businesses.
1. Cash Flow to Debt
(Net income + depreciation) / total debt
Why do some businesses make monthly money but still have cash flow problems? One of the reasons is that most of the cash is used to pay debt. Debt is a silent executioner, if not managed continuously. Cash flow is the main reason for business failure. Aim for a cash flow to debt ratio of more than one to be able to cover your expenses.
2. Net Profit Margin
(Total revenue – Total expenses) / Total revenue
The total expenses comprise operating expenses, tax, and interest. This ratio indicates to investors and financiers how successfully the business manages expenses, thus converting revenue in profit. This indicates how much profit is made from each Rand of revenue. In other words, a 15% net profit ratio means that 15 cents of each Rand sold is kept as profit. A poor or declining profit margin can be indicative of a variety of problems e.g., sales are declining due to poor customer service, expenses are out of hand or employee theft is a problem. When the products are priced correctly, and good expense control is exercised the net profit ratio is high.
3. Gross Profit Ratio
(Sales -cost of sales) / total sales
This is an important ratio for a business that sells products. This ratio can be calculated for an individual item and overall. The higher the Gross profit ratio, the more money is available to pay operating expenses like marketing, rent and salaries. There are three ways to increase a low gross profit ratio. The selling prices and or sales volume must increase, and the expenses must be scrutinised to reduce unnecessary costs.
4. Acid test
(Cash + liquid investments + net accounts receivable) / current liabilities
The current liabilities comprise accounts payable, short-term loans including credit card debt, taxes, and any accruals. The acid test is indicative if the business is liquid enough to cover current liabilities in the case of unforeseen circumstances. A ratio of 2.0 means that the business has R2.00 cash to cover R1.00 of current liabilities. Thus, the higher this ratio the better the outlook. When the current liabilities are more than the cash available the ratio will be less than 1.00. The options to improve the ratio is to pay off the current liabilities and to increase the liquid assets in the business. This ratio does not include inventory because it takes time to convert inventory to cash. The Current ratio includes inventory and is indicative of the business’s ability to pay current liabilities by liquidating current assets. The Current ratio is calculated by dividing current liabilities by current assets.
5. Accounts receivable turnover
(Total accounts receivable/total sales) * Number of days
This ratio is indicating how long the business is getting paid after a sale has been made. The higher the ratio the longer it takes to be paid. As mentioned earlier cash flow is crucial for any business, thus a process to manage the receivables is of utmost importance.
6. Inventory turnover ratio
Cost of sales / average inventory
Obviously, this ratio is for businesses carrying inventory. It tells the business owners, investors, potential buyers, and financiers how many times inventory was converted to sales within a specific period.
Inventory generally has the highest value in the Statement of Financial Position and is used to determine how liquid the company’s inventory is. Inventory can be used as collateral for loans, investors will look at this ratio and therefore inventory must be easily and quickly converted to cash. A low ratio is indicative of cash that is tied up in slow-moving or non-sellable products. The type of inventory the business carries, like food or expensive jewellery, must be considered when calculating the ratio. Food by its very nature, will have a higher ratio. It is worthless for the business if inventory is not sold.
What story do your business numbers tell the stakeholders? Luckily you as the business owner are the director and can control the outcome.
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