Need Help Interpreting Financial Statements? Read This.
Every three months I sit down at my desk to start the hideous prep work that is involved with preparing that Dreaded Business Activity Statement. The positive side of undertaking all that work and heartache is that the business has reached another milestone.
I like to measure my business based on three-month milestones, it works out nicely withal the BAS paperwork needed and I can plan my next 3 month goals and adjust my future business plan based on what trends I am seeing.
I thought I would share some of the key ratios that I use to determine how the business is travelling through on its journey.
1. Debtor Days
This is an analysis that shows how quickly customers are paying their accounts, or in other words, how many days you are providing credit to your customers.
It is determined by taking the closing Debtor (or Accounts Receivable) balance at the end of the period and dividing it by the average Sales per day (Sales / number of days in period). This is a useful check against previous periods and the smaller the number the better your cash flow is going to be.
2. Inventory Days
This ratio is to provide the owner with a gauge as to how long they are holding inventory for. Depending on the information you have access to, it is best broken down into different inventory categories, to better guide you how you can improve ordering efficiencies and whether discounting may need to be applied.
It is calculated by taking the Cost of Sales for the period divided by the Average Inventory (average of both the Opening & Closing). The smaller the number the more frequent your inventory turns over.
1. Creditor Days
This ratio is somewhat similar to the abovementioned Debtors Days, however it calculates how efficiently you, as the customer, are utilising the credit terms offered to you by your suppliers.
It is calculated by taking the closing Creditors (or Accounts Payable) figure at the end of the period and dividing it by the average Cost of Sales per day (i.e Cost of Sales divided by the number of days in the period of review).
2. Working Capital Ratio
This ratio helps the manager understand the businesses liquidity or how well it can function moving forward. It is calculated by taking the total of the Current Assets and dividing it by the total of the Current Liabilities. Ideally, you want the number to be greater than 1, which means you have enough liquid assets to cover your immediate debts.
3. Short Term Debt Ratio
The ShortTerm Debt Ratio is calculated by taking the Profit and adding back Depreciation then dividing this by the Current Liabilities. The ratio shows the business’ ability to fund its short-term debts without having to sell down any current assets. Current Assets usually include Cash, Receivables, Inventory and Deposits and possibly any short-term investments or loans.
1. Gross Profit Ratio
The Gross Profit is a good first check to see where any profitability problems lie. The calculation is Sales – Cost of Sales then compared back to the Sales to provide a percentage. Ideally, you want this percentage to stay steady or increase over time. It is a quick way to see if your prices are too low or if your purchases are costing too much. As a guide retail industries generally see ratios of 50%, restaurants generally 80% and professional services are around 65%.
2. Net Profit Ratio
Ah, my favourite ratio of all, when this is up, the happier all business owners become… It is calculated by taking the Net Profit and comparing it back against the Sales to provide a percentage.
Now you can apply some of these key ratios to your business and may everyone’s Net Profit Ratio increase each and every period.
“The opinions expressed by Smallville Contributors are their own, not those of www.smallville.com.au"
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