General business finance

Checking the financial health of your business

Running a business is a bit like maintaining your car. By checking key indicators like oil and water regularly, you can keep your car running well, and identify small problems to fix before they turn into big ones.

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Key ratios

Regularly checking some key ratios helps you see how well your business is performing. Ratios measure two or more values in your financial statement.

In this guide, we’ll look at the four most common types of ratios used by business owners, how to calculate them, and how to use them.

The list of ratios we’ve outlined here is not exhaustive – your accountant can help you identify the key ratios for your business.

You can get the figures you need from your accounting software (it may even work out the ratios for you).


How to prepare your financial statements

Learn about the two main financial statements for your business: the Balance Sheet and the Profit and Loss Statement, and how to calculate some key finance ratios like profitability, business efficiency, or business liquidity ratios.

Profitability ratios

Check these ratios to see if your business is making enough profit.

Gross profit margin ratio

This ratio shows whether your average mark-up is enough to cover all of your expenses and show a profit. The calculation below shows you how, or you can use our gross profit margin calculation to work this out. 

Gross profit ÷ annual sales x 100 = %

Your gross profit is your sales minus your cost of goods sold (CoGS) – the direct cost of generating that revenue (such as purchasing raw materials), but not overheads like salaries. Read about the difference between direct costs and overheads

For example:

  • Let’s say you made $200,000 in annual sales, but your CoGS was $160,000 – giving a gross profit of $40,000.
  • Ratio: Gross profit ($40,000) ÷ annual sales ($200,000) = 0.2 x 100 = 20%.

Aim for a percentage at least as high as similar businesses in your industry. If your margin is low compared to industry norms, you might be under-pricing. If your margin is high but business is slow and profits are weak, you might be over-pricing. Read about how to set your prices

Return on equity ratio

This ratio shows whether you are receiving a good enough return on your investment in your business.

Net profit after tax ÷ owner’s equity x 100 = %

For example:

  • Let’s say last year’s net profit was $10,000 after tax. Net profit is your total revenue minus total expenses. It’s found on the last line of your income statement or profit and loss statement, which is why it’s often referred to as ‘the bottom line’.
  • Your owner’s equity is $100,000. Owner’s equity is your ownership in the business – how much money you’ve invested to start or buy the business, plus any profit left in the business over the years. You can find this figure on your balance sheet. 
  • Ratio: Net profit ($10,000) ÷ owner’s equity ($100,000) = 0.10 x 100 = 10%.

Your return on equity percentage should be at least as high as the interest you could otherwise earn on that money at the bank or in a safe investment. Many see 20% to 25% as a minimum acceptable return on equity.

Business efficiency ratios

These will tell you if there are parts of your business that aren’t running as well as they should be.

Rate of stock turn ratio

This ratio shows how quickly you turn over your stock.

Cost of goods sold (CoGS) ÷ average stock value = X

For example:

  • Your CoGS is $100,000. CoGS = opening stock plus purchases, minus closing stock.
  • Your average stock value is $20,000. Average stock value = opening stock plus closing stock, divided by two.
  • Ratio: CoGS ($100,000) ÷ average stock value ($20,000) = 5. Your business is turning its stock over five times per year.

Use typical figures for your industry as a benchmark and aim to meet or exceed it. You want the highest stock turnover possible, while making sure you don’t run out. A low stock turn could mean you have too much stock, or too much of it is out-of-date or selling poorly – and costing you money.

Debtor days ratio

This ratio shows how efficient your business is at collecting debt. The faster you collect debt, the better your cash flow situation.

Value of your debtors ÷ annual credit sales x 365 days = X

The value of your debtors is the money owed to you by customers – you can find this on your balance sheet. Annual credit sales are sales that you’ve issued an invoice for (not cash sales).

For example:

  • The value of your debtors is $35,000, and your annual credit (invoiced) sales are $252,000.
  • Ratio: Debtors ($35,000) ÷ Annual Credit Sales ($252,000) x 365 = 51. It takes your business an average of 51 days to collect debt.

Compare your debtor days with the credit terms you allow. Normal credit terms (20th of the month following invoice) give debtors around 40 days to pay. Remember, you’re in business to make a profit, not to finance other businesses with ‘cheap’ money by letting them get away with not paying you. Read about how to make sure you get paid.

Expenses ratio

This shows whether your expenses are increasing faster than your sales.

Total expenses ÷ annual sales x 100 = %

For example:

  • Your total expenses are $40,000 and your annual sales are $200,000.
  • Ratio: Total expenses ($40,000) ÷ annual sales ($200,000) = 0.2 x 100 = 20%. That is, you incurred $20 of expenses for each $100 of sales.

Always aim to keep your expenses as low as possible, and comparable to previous years. A deteriorating expenses ratio could mean you're letting expenses creep up unnecessarily.

Creditor days ratio

This shows how long it takes you to pay creditors. You don’t want to pay sooner than you need to, but taking too long to pay can indicate problems in your business. 

Creditors (accounts payable) ÷ purchases x 365 days = X

For example:

  • Your accounts payable is $50,000 and your purchases come to $250,000.
  • Ratio: Creditors ($50,000) ÷ purchases ($250,000) x 365 = 73 days. On average, it takes your business 73 days to pay its debts.

Compare the result with your creditors’ average credit terms, as well as the previous year’s ratios. You can get a more useful figure by ignoring items such as advertising, electricity, and phone costs and instead concentrating on your trade creditors. 

A deteriorating creditor days’ ratio signals business problems or poor cash flow management. If your payment time is longer than the average credit terms you receive from your creditors, it might mean your business is short of cash. You might also be missing out on discounts for prompt payment. 

To learn more, check out our video about how to manage cash flow.

The importance of cash flow

Cash flow is the lifeblood of every business – whether you’re contracting, self-employed or running a successful small business. In this video you’ll learn how to set up a cash flow forecast, how to forecast sales and outgoings, and get tips on how to improve your cash flow.

Business liquidity ratios

These ratios can indicate if your business is solvent.

Current ratio (or ‘working capital’ ratio)

This shows your ability to pay your bills when they fall due.

Current assets ÷ current liabilities = X

For example:

  • Your current assets are $300,000. Your current liabilities are $100,000.
  • Ratio: Current assets ($300,000) ÷ current liabilities ($100,000) = 3. Your current ratio is 3 to 1 (or 300%).

To have enough money to meet your short-term commitments, you need greater assets than liabilities at all times. Aim for a ratio of at least 2 to 1 (or 200%).

Your current ratio depends on the cash cycle of your business – that is, on factors such as stock turn and debtor collection times. Improve your rate of stock turn and debtor days’ ratios, and you’re likely to improve your current ratio as well. Read about how to improve your working capital.

Quick ratio (or ‘liquidity’ ratio)

This ratio measures how much ready money (also known as ‘quick money’ or ‘liquid assets’) you have on hand to pay bills. This ratio is particularly important if you have a lot of money tied up in stock, because you can’t always free up that money quickly to pay bills.

Current assets – stock ÷ current liabilities x 100 = %

For example:

  • Your current assets are worth $50,000, but $40,000 of that is stock. Your current liabilities are worth $12,000. 
  • Ratio: Current assets ($50,000) – stock ($40,000) = $10,000 ÷ current liabilities ($12,000) = 0.83 x 100 = 83%.

Aim for at least 100% or a ratio of 1:1. This means you’ll have all of the ready money you need to pay your debts. Less than 100% (such as in the example) signals payment difficulties that could lead to other problems.

To calculate these business liquidity ratios, you’ll need to understand your assets and liabilities. You can find these on your balance sheet.

Financial structure of the business

Use this ratio to see whether your business may be undercapitalised.

Ownership ratio (or ‘equity to assets’ ratio)

This shows you how much of the business you actually own.

Owner’s equity ÷ total assets x 100 = %

When calculating total assets, ignore intangible assets such as goodwill. 

For example:

  • Your owner’s equity (total assets of the business minus liabilities) is $100,000. Your total assets are $200,000.
  • Ratio: Owner’s equity ($100,000) ÷ total assets ($200,000) = 0.5 x 100 = 50%.

Aim for an ownership ratio of at least 40%. A low ownership ratio means your business may be undercapitalised, which can lead to unacceptable risk and make it hard to borrow money. 

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