Small Business Management Toolbox: Manage finances

Small Business Management Toolbox
Manage finances
Ratio analysis
Profitability ratios
These ratios wil help you to evaluate your business profit performance for a
particular period. In the process you wil assess the returns generated on sales, total
assets and capital.
The fol owing are the most commonly used profitability ratios.
•
Gross profit margin
•
Net profit margin
•
Return on total assets
•
Return on equity
Gross profit margin
The gross profit is the sales less cost of goods sold. These figures are contained in
your profit and loss statement.
Gross profit
Gross profit margin =
×100
Sales
The ratio of gross profit to sales should be relatively constant for a business and the
industry, irre €
sp
ective of fluctuations in the net profit ratio. If your gross profit margin
has been decreasing over time, it may mean that your stock control needs to be
examined and improved, or that your sel ing prices are not increasing in line with the
costs of the goods you sel .
Net profit margin
This ratio represents how much of each sales dol ar is left for the owner after al costs
have been met. It is calculated as fol ows.
Net profit
Net profit margin =
×100
Sales
The figure usual y used for comparison purposes is the net operating profit. It is
operating profit afte€
r i ncome tax, but excluding extraordinary items.
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Small Business Management Toolbox
Manage finances
Ratio analysis
Return on total assets
This ratio measures how effectively your business uses its assets to produce more
income. Of if you prefer, the average rate of return earned by your business’ assets
over a set period.
This ratio is measured by dividing operating profit after tax by average total assets.
Operating profit after income tax
Return on total assets =
Average total assets
A high return on total assets can be a result of a high profit margin, a rapid turnover
of a
€
sset s, or a combination of both.
Return on equity
The return on equity ratio measures the rate of return on shareholders’ or owners’
investment. It assesses the net profit performance against the money the owners
have invested in the business.
This ratio can be calculated using the fol owing formula.
Operating profit after income tax
Return on equity =
Owner's equity
The rate of return can be compared to what you would have earned had you invested
your cap€
it
al in the share market or in a bank account during the same period.
If your business has a high return of assets or uses debt financing extensively, the
rate of return is likely to be higher.
Also note that for companies the percentage of return on equity may in reality be
higher than what you have calculated, as the operating profit would take into account
any salaries paid to yourself or other owner-employees. Your business stock
valuation policy, asset valuation policy and treatment of borderline expense/capital
items wil also have an impact on this ratio.
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Small Business Management Toolbox
Manage finances
Ratio analysis
Liquidity ratios
These ratios show the ability of your business to quickly generate the cash needed to
pay your bil s. They are important to your business as they can point to cash
deficiencies, which if not rectified quickly could impact on your profitability, and in
severe cases could send your business bankrupt.
Liquidity ratios are sometimes cal ed working capital ratios because that is, in effect,
what they measure. The two ratios most commonly analysed are:
•
the current asset ratio
•
the quick asset ratio or ‘acid test’.
The current asset ratio
This ratio measures the ability of your business to generate cash to meet its short-
term obligations. A decline in the current ratio could be due to an increase in short-
term debt, a decrease in current assets, or a combination of both.
This ratio is calculated by dividing current assets by current liabilities and expressing
the answer as a ratio, eg 2:1.
Current assets
Current asset ratio = Current liabilities
A decline in this ratio means a reduced ability to generate cash. By paying off some
current liabilitie€
s you can improve your current asset ratio.
The quick asset ratio or ‘acid test’
This ratio examines your business’ ability to quickly meet short-term debts. The
difference between the quick asset ratio and the current asset ratio is that the quick
asset ratio subtracts stock from current assets and compares the resulting figure to
current liabilities. The formula for this ratio is as fol ows.
Current assets - Stock
Quick asset ratio =
Current liabilities
€
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Small Business Management Toolbox
Manage finances
Ratio analysis
The reason that stock is not included with the current assets is that if the business
had to quickly liquidate stock, it is unlikely to realise the value stated on the balance
sheet. Similarly, the current liabilities included in this ratio should only be those items
requiring payment in the short-term. This would include trade creditors and accrued
expenses, but it would not include bank overdrafts unless it is likely to be cal ed at
short notice.
© Australian National Training Authority (ANTA) 2003. Al rights reserved
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