At CRM, we like nothing better than getting stuck into a spot of number crunching. Understanding the key numbers of our clients’ businesses is what we’re passionate about because we know that by evaluating the most important numbers – or financial ratios – we can analyse trends and help businesses to be the best they can be.
Where do financial ratios come from?
Financial ratios are usually taken from a company’s income statement, balance sheet and cash flow. Financial ratios show the relationship between financial statements and are used to analyse the company’s profitability, liquidity, assumed risks and financial stability.
Which ratios to choose?
On its own, a financial ratio isn’t that useful so the skill comes in knowing which ratios to measure and how to interpret the data when collected. There are dozens of ratios that are useful to business owners, analysts and investors, let’s look at those most commonly used in performance evaluation:
1. Liquidity Ratios
The most common measurement is the current ratio – the ratio of current assets to current liabilities – indicating a company’s ability to pay its bills. A ratio of less than one shows the company has more liabilities than assets and the higher the ratio, the more liquid the company is. The current ratio isn’t a perfect barometer, but it is a good start and should be monitored for big decreases over time. Make sure the accounts listed in “current assets” are collectable.
2. Solvency Ratios
Solvency ratios indicate financial stability by measuring a company’s debt relative to its assets and equity. A company with too much debt has less flexibility to manage its cash flow or in deteriorating business conditions.
The most common solvency ratios are debt-to-asset and debt-to-equity. The debt-to-asset ratio is the ratio of total debt to total assets. The debt-to-equity ratio is the balance between the money or assets owed versus the money or assets owned. A lower ratio reduces financial risk while a higher ratio realises the return benefits of financial leverage.
3. Profitability Ratios
The most important profitability ratios are net profit margin and gross profit margin. The net profit margin measures what percentage of profit the company is generating for every pound of turnover it earns. Very useful in preparing forecasts, the higher the number the better!
The gross profit margin indicates the percentage of turnover that is not paid out in direct costs (costs of sales). An important measurement used in business planning to indicate what percentage of gross profit can be generated by future turnover – the more efficient the company, the higher the number. Gross margins are a leverage tool, which means that small improvements can drive large net profits.
There are many, many more financial ratios and it is important to find the most relevant measurements for your business. Using ratios clearly shows how your business is performing year on year.
At CRM, we work with clients to tailor the measurement of the best financial ratios as part of our 8 Step Business Improvement Programme (Evaluation is Step 4). To find out more, check out our website or give CRM a call on 01865 379272.