Ratios are an invaluable tool for managers to quickly assess the current financial position of an organisation. In this article are a range of key financial measures which you can quickly calculate, using your balance sheet and profit and loss reports produced from your accounting system.

It should be said that these ratios are only as good as the quality of your information, Rubbish In Rubbish Out, so you should ensure you have an accurate and up to date bookkeeping system before using these, or the results could be misleading.

Debt Ratio

The debt ratio gives an indication of the gearing level of your business, ie the level of debt to equity – that is the ability of the company to cover it’s debts with it’s assets. The right level of debt for a business depends on many factors.

Some advantages of higher debt levels are:

• The deductibility of interest from business expenses can provide tax advantages.
• Returns on equity can be higher.
• Debt can provide a suitable source of capital to start or expand a business.

Some disadvantages can be:

• Sufficient cash flow is required to service a higher debt load. The need for this cash flow can place pressure on a business if income streams are erratic.
• Susceptibility to interest rate increases.
• Channelling cash flow to service debt may starve expenditure in other areas such as development which can be detrimental to overall survival of the business.

The calculation used to obtain the ratio is below, information for which can be found on the balance sheet:

Debt Ratio= (Total liabilities/Total assets) * 100

Debt to Income Ratio

The debt to income ratio gives an indication of the sustainability of the debt load of your business. The debt to income ratio provides a simple measure of the total liabilities of a business compared to its income.

Both the amount and the stability of income streams have a bearing on the level of sustainable debt. In general, larger business operations and those with stable cashflow can sustain higher debt ratios provided they have efficient costs structures. The debt to income ratio can be important in the risk management process of a business.

The calculation used to obtain the ratio is below, the information for which can be found on the P&L:

Debt to Income = Total Liabilities / Total Income

Net Profit Margin

For a business to survive in the long term it must generate profit. Therefore the net profit margin ratio is one of the key performance indicators for your business. The net profit margin ratio indicates profit levels of a business after all costs have been taken into account.

It is worth analysing the ratio over time. A variation in the ratio from year to year may be due to abnormal conditions or expenses. Variations may also indicate cost blowouts which need to be addressed.

A decline in the ratio over time may indicate a margin squeeze suggesting that productivity improvements may need to be initiated. In some cases, the costs of such improvements may lead to a further drop in the ratio or even losses before increased profitability is achieved.

The calculation used to obtain the ratio is below, the information for which can be found in the P&L:

Net Profit Margin = ( Net Profit / Sales) x 100

Gross Profit Margin

Your business' gross profit margin is one of its key performance indicators. The gross profit margin gives an indication on whether the average mark up on goods and services is sufficient to cover expenses and make profit. The gross profit margin should be stable over time. A persistent gradual decrease is likely to indicate that productivity needs to be increased to return profitability back to previous levels.

The calculation used to obtain the ratio is below, the information for which can be found in the P&L:

Gross Profit Margin = ( Gross Profit / Sales) x 100

Working Capital

The working capital ratio can give an indication of the ability of your business to pay its bills.

Generally a working capital ratio of 2:1 is regarded as desirable. However the circumstances of every business vary and you should consider how your business operates and set an appropriate benchmark ratio.

A stronger ratio indicates a better ability to meet ongoing and unexpected bills therefore taking the pressure off your cash flow. Being in a liquid position can also have advantages such as being able to negotiate cash discounts with your suppliers.

A weaker ratio may indicate that your business is having greater difficulties meeting its short-term commitments and that additional working capital support is required. Having to pay bills before payments are received may be the issue in which case an overdraft could assist. Alternatively building up a reserve of cash investments may create a sound working capital buffer.

Ratios should be considered over a period of time (say three years), in order to identify trends in the performance of the business.

If you decide your business's current ratio is too low, you may be able to raise it by:

• Paying some debts.
• Increasing your current assets from loans or other borrowings with a maturity of more than one year.
• Converting non-current assets into current assets.
• Increasing your current assets from new equity contributions.
• Putting profits back into the business.

The calculation used to obtain the ratio is below, the information for which can be found on the balance sheet:

Working Capital Ratio (also referred to as the Current Ratio) = Current Assets / Current Liabilities

Current Liabilities

Quick Assets Ratio

The quick assets ratio gives an indication of the level of liquid assets that can be used to meet short term liabilities. The quick assets ratio provides a more conservative measure than the working capital ratio in that it excludes stock (inventory). A ratio greater than 1:1 (i.e. 2:1) indicates that current liabilities can be met from current assets without having to liquidate stock.

Ratios should be considered over a period of time (say three years), in order to identify trends in the performance of the business.

The calculation used to obtain the ratio is below, information for which can be found on the balance sheet:

Quick Assets Ratio = (Current Assets - Stock ) / Current Liabilities

Acid Test Ratio

The Quick Ratio is sometimes called the "acid-test" ratio and is one of the best measures of liquidity. It is figured as shown below:

                            Cash + Government Securities + Receivables

Quick Ratio = _________________________________________

                                         Total Current Liabilities

The Acid Test Ratio is a much more exacting measure than the Current Ratio. By excluding inventories, it concentrates on the really liquid assets, with value that is fairly certain. It helps answer the question: "If all sales revenues should disappear, could my business meet its current obligations with the readily convertible `quick' funds on hand?"

An acid-test of 1:1 is considered satisfactory unless the majority of your "quick assets" are in accounts receivable, and the pattern of accounts receivable collection lags behind the schedule for paying current liabilities.

Stock Turnover

The stock turnover ratio indicates how quickly your business is turning over stock. A high ratio may indicate positive factors such as good stock demand and management. A low ratio may indicate that either stock is naturally slow moving or problems such as the presence of obsolete stock or good presentation. A low ratio can also be indicative of potential stock valuation issues. It is a good idea to monitor the ratio over consecutive financial years to determine if a trend is developing.

It can be useful to compare this financial ratio with the working capital ratio. For example business operations with low stock turnover tend to require higher working capital.

The calculation used to obtain the ratio is:

Stock Turnover Ratio = Cost of Goods / Average Stock

Debtor Ageing Ratio

The debtor ageing ratio indicates the average time it takes your business to collect its debts. It's worth looking at this ratio over a number of financial years to monitor performance trends.

A ratio that is lengthening can be the result of some debtors slowing down in their payments. Economic factors, such as a recession, can also influence the ratio. Tightening your business' credit control procedures may be required in these circumstances. The debtor ageing ratio has a strong impact on business operations particularly working capital. Maintaining a running total of your debtors by ageing (eg. current, 30 days, 60 days, 90 days) is a good idea, not just in terms of making sure you are getting paid for the work or goods you are supplying but also in managing your working capital.

The calculation used to obtain the ratio is:

Debtor Ageing Ratio (in days)= (Trade debtors / Sales) * 365

Creditor Ageing Ratio

The creditor ageing ratio indicates the average time it takes for your business to pay its bills.

Use information from your annual profit and loss statement along with the trade creditors figure from your balance sheet for that financial year to calculate this ratio.

This ratio provides an indication of the average time it takes for your business to pay its bills. It's worth looking at the figure over a number of financial years to see if a trend is developing. A lengthening in the ratio could indicate a problem with working capital, such as decreasing stock turnover or slower debt collection.

The calculation used to obtain the ratio is:

Creditor Ageing Ratio (in days) = ( Trade Creditors / Purchases) x 365

Return on Investment (ROI) Ratio.

The ROI is perhaps the most important ratio of all. It is the percentage of return on funds invested in the business by its owners. In short, this ratio tells the owner whether or not all the effort put into the business has been worthwhile. If the ROI is less than the rate of return on an alternative, risk-free investment such as a bank savings account, the owner may be wiser to sell the company, put the money in such a savings instrument, and avoid the daily struggles of small business management. The ROI is calculated as follows:

                                         Net Profit before Tax

Return on Investment = ____________________

                                                Net Worth

These Liquidity, Leverage, Profitability, and Management Ratios allow the business owner to identify trends in a business and to compare its progress with the performance of others through data published by various sources. The owner may thus determine the business's relative strengths and weaknesses.

Information Sourced From Anz.com.au, and ACCA Global