Financial ratios are used to identify either how well you are doing, or as a red flag to signal something needs addressing in the future. It could be something simple like comparing sales to marketing costs.

For example, if this years’ sales are $1m and you spent $50k on marketing, the marketing/sales ratio is 5%. You can now compare how effective your marketing is year-to-year, by seeing if the percentage changes. An increase could mean your tactics are less effective, as you’re spending more on marketing relative to sales.

Getting the Most Out of Financial Ratios

In most cases, the usefulness of these ratios depends on a clear understanding of the relationship between the numbers used and their implications for your day-to-day business.

Ratios themselves are best at helping you identify why they may be changing, before you make a decision. There will be times when you’re comfortable with a deteriorating ratio if other parts of the business are succeeding. For example, if your turnover increases from $2 million to $3 million, and net profit rises from $200,000 to $250,000, you’ve made more money, but the actual profit/sales ratio has deteriorated. Year one profit to sales is 10%, and year two it’s fallen to 8.3%.

This in itself may be acceptable as you’ve made an extra $50k in profit, but to generate that, you’ve needed to increase sales by $1m. This marketing budget increase could be fine if your overall net profit is also growing.

Let’s take a closer look at some of the ratios you can review.

Current Ratio

This measures your business’s liquidity, i.e. how easily you can access cash or convert assets into cash to meet short-term obligations like paying suppliers, wages, rent, or loan instalments.

To calculate it, divide your current assets by your current liabilities. This gives you a snapshot of whether your assets are sufficient to cover your debts.

For example:

• If your current assets are $500,000 and your liabilities are $250,000, your ratio is 2:1. This means you have twice as many assets as debts, which is a healthy position.
• On the other hand, if the ratio is flipped, with $250,000 in assets and $500,000 in liabilities, you’d have twice as much debt as assets. In such a case, paying all your bills at once could be challenging, and you might need to secure additional financing.

Maintaining a balanced current ratio is crucial for making sure your business can meet its short-term financial commitments.

Gross Profit Ratio

This ratio measures your gross profit as a percentage of turnover.  For example, if your turnover is $2 million and your cost of sales is $600k, you’ve made a gross profit of $1.4 million.  It’s easy to turn this into a percentage: $1.4m divided by $2m equals 70%.

• Every $100 of sales therefore generates $70 towards paying expenses and contributing to net profit.
• Reasons may include rising inventory costs, offering too many discounts, shrinkage, theft or wastage, or selling more products with lower margins.

If you gross margin percentage starts to slip over time, it’s an indication that you need to find out why and act.

Net Profit Margin

This measures the percentage of each dollar of sales that remains as profit after all expenses, including operating costs, taxes, and interest, have been deducted. It gives a clear picture of your business’s overall profitability.

If your business has a turnover of $2 million and a net profit of $300,000, your net profit margin is 15%. This means for every $1 of sales, your business keeps 15 cents as profit.

Improving your net profit margin involves increasing efficiency and reducing costs. Some strategies include:

• Evaluating if your customers are willing to pay more for your products or services without affecting sales volume.
• Looking for ways to reduce fixed costs like rent, utilities, or salaries without compromising quality or operations.
• Shifting your attention to offerings with a higher profit margin to maximize earnings.
• Implementing cost-saving measures or more efficient processes to reduce waste and improve profitability.

A healthy net profit margin is a key indicator of a sustainable and successful business. Regularly reviewing this metric helps you stay on top of your financial performance and make informed decisions for improvement

Return on Capital Employed

This ratio helps show what return you’re making on the money financing the business. If you have $5 million in capital in the business, and earn $250k profit, this is a 5% return on capital invested. You need to determine if your capital would earn better a return in another investment if you sold the business.

Of course, it’s not always practical to sell, and often you’re drawing a salary, wage or dividends from the business. But it could be worth considering if you have very large amounts of capital tied up in the business, like equipment, and you’re generating a very low return.

Expense to Sales Ratio

Take any expense and divide it by sales, to see how much each contributes to the success of the business. For example, you can see if your employee ratio is remaining stable, by dividing wages into sales. If the percentage is increasing, then you’re spending more on employees per dollar of sales than in the past.

Next Steps

• Decide which ratios mean something in your business and start tracking. Set up regular reporting so it’s easy to see each month your progress.
• Use the insights gained from tracking your ratios to inform your decision-making, such as identifying areas for cost reduction, pricing adjustments, or investment opportunities.
• Get help from your accountant or financial adviser.

A ratio on its own is less useful than compared to your data from previous years, or data from similar businesses, which allows you to benchmark. If you can, utilize benchmarking data of businesses in your industry to find out where you’re doing well and where you should set improvement goals.

If you have any questions about the above ratios and how they apply to your business, you can always reach out to Diamond’s Business Services team.