Running a business is a bit like maintaining your car. By checking key indicators like oil, water, temperature and tyres regularly, you can keep your car running well, and identify and fix small problems before they turn into big ones.
You can do the same for your business by regularly checking some key ratios. It sounds technical, but it’s actually quite simple. It’s little more than dividing one figure by another to get a ratio. You can get the figures you need from your accounting software - it may even work out the ratios for you.
Just as your temperature gauge tells you whether your car is overheating or not, these ratios can tell you how well your business is performing – so it pays to check them regularly.
In this article we’ll look at some of the common ratios used by business owners, how to calculate them, and how to use them. The key is to compare your ratios against a suitable benchmark such as previous years, or industry averages, to assess how well your business is doing. This is not an exhaustive list – your accountant can help you identify the key ratios for your business.
1. Profitability ratios
Check these ratios to see if you’re making enough profit.
Gross profit margin
This shows whether your average mark-up is enough to cover all your expenses and show a profit. Simply divide your gross profit by your annual sales and multiply by 100 to get a percentage.
Note: your gross profit is your sales minus your ‘cost of goods sold’ (the direct cost of generating that revenue such as raw materials, but not overheads like salaries). In the example below the business made $200,000 in annual sales but the cost of goods sold was $160,000, giving a gross profit of $40,000. Your gross profit is shown on your income statement, and you can use your accounting software to find it.
Ratio: gross profit ($40,000) divided by annual sales ($200,000) is 0.2, multiplied by 100 equals 20%.
Aim to achieve 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 (for tips on setting your prices see our guide ‘Getting your price right’).
Return on equity
This shows whether you are receiving a good enough return on your investment in your business. Simply divide your net profit after tax by Owner's Equity.
Your net profit is simply your total revenue minus total expenses. It’s found on the last line of your income statement (which is why it’s often referred to as ‘the bottom line’.
You can find your Owner's Equity figure on your Balance Sheet (see our guide on ‘Understanding your balance sheet’). It represents 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).
Ratio: net profit ($10,000) divided by Owner’s equity ($100,000) is 0.10, multiplied by 100 equals 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, given the risk associated with starting and running a small business.
2. Business efficiency ratios
Checking these next four ratios will tell you if there are areas in your business that aren’t operating as well as they should.
Rate of stock turn
This shows how quickly you turn over your stock. Calculate it by dividing your Cost of Goods Sold (CoGS) by the value of your Average Stock.
CoGS = Opening Stock + Purchases - Closing Stock
Average Stock = Opening Stock + Closing Stock ÷ 2.
Cost of Goods Sold:
Ratio: Cost of Goods Sold ($100,000) divided by Average Stock ($20,000) equals 5 (in other words, you're turning your stock over five times per year).
Ask your accountant for typical figures for your industry and aim for that benchmark or better. 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 in general, or you hold too much stock that’s out-of-date or selling poorly – and costing you money.
This shows how efficient your business is at collecting debt. The faster you collect debt, the better your cashflow situation.
To calculate this ratio, divide the value of your debtors (the money owed to you by customers – you can find this on your balance sheet) by annual credit sales (sales that you’ve issued an invoice for, not cash sales), then multiply by 365 (days in the year).
Value of debtors:
Ratio: debtors ($35,000) divided by annual credit (invoiced) sales ($252,000), times 365 days equals an average of 51 days to collect debt.
Annual credit (invoiced) sales:
Compare your debtor days with the credit terms you allow. For example, normal credit terms, (20th of month following invoice) gives debtors on average 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. Check out our article 'Five steps to make sure you get paid' for some useful tips.
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. Calculate it by dividing your Creditors (Accounts Payable) by your Purchases and then multiply by 365 (days in the year). Compare the result with your creditors’ average credit terms, as well as the previous year's ratios.
Ratio: Creditors ($50,000) divided by Purchases ($250,000), times 365 equals 73 days to pay your debts.
Note: you can get a more useful figure by ignoring items such as advertising, electricity and phone costs and instead concentrating on your trade creditors.
If your payment time is longer than the average credit terms you receive from your creditors, it might indicate that your business might be short of cash. You might be missing out on discounts for prompt payment. A deteriorating creditor days’ ratio signals business problems or poor cashflow management.
This shows whether your expenses are increasing faster than your sales (which will have a negative impact on your profits). Calculate it by dividing your Total Expenses by Annual Sales.
Ratio: Total Expenses ($40,000) divided by Annual Sales ($200,000) equals 0.2 or 20% (that is, you incurred $20 of expenses for each $100 of sales).
Always aim to keep your expenses as low as possible, and broadly comparable to previous years. Even if the business is doing well, a deteriorating expenses ratio can be an early signal that you're letting expenses creep up unnecessarily.
3. Business liquidity ratios
These two checks tell you whether your business is solvent.
This shows you whether you can pay your bills when they fall due. To calculate your current ratio, divide Current Assets by Current Liabilities. For example:
Ratio: Current Assets ($300,000) divided by Current Liabilities ($100,000) equals 3 (3 to 1 or 300%).
You need greater assets than liabilities at all times. Aim for a ratio of at least 2 to 1 (or 200%). In other words, aim for $2 in assets for every $1 of liabilities, so you have enough money to meet your short-term commitments.
Note: the current ratio (sometimes called a working capital ratio) depends on the cash cycle of the business, that is, on factors such as stock turn and debtor collection times. Improve the stock turn and debtor days’ ratios, and you're likely to improve your current ratio as well. (See our guide on ‘How to improve your working capital’ for more information and tips).
The quick (liquidity) ratio is an even tougher test than your current ratio because it leaves out stock. It measures how much ready money (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.
To calculate this, subtract the Stock figure from your Current Assets (Cash plus Debtors, then divide the result by Current Liabilities and multiply by 100 for a percentage.
Ratio: $50,000 less $40,000 is $10,000, divided by $12,000 equals 0.83, multiplied by 100 is 83%.
(Less Stock of $40,000)
The business in this example only has 83% of the ready money it needs to pay debts (or 83 cents for each dollar of debt). This result signals payment difficulties that could lead to other problems. Aim to have at least 100% or a ratio of 1:1.
4. Financial structure of the business
This check tells you whether your business may be undercapitalised.
Equity to assets (Ownership ratio)
This ratio shows you how much of the business you actually own. Calculate it by dividing the Owner's Equity (the Total Assets of the business minus Liabilities) by Total Assets (ignore intangible assets such as goodwill).
Ratio: $100,000 divided by $200,000 equals 0.5 or 50%.
This material is provided as a complimentary service of ANZ Bank New Zealand Limited ("bank"). It is prepared based on information and sources the bank believes to be reliable. It is subject to change and is not a substitute for commercial judgement or professional advice, which should be sought prior to acting in reliance on it. To the extent permitted by law the bank disclaims liability or responsibility to any person for any direct or indirect loss or damage that may result from any act or omission by any person in relation to the material.
This material is for information purposes only. Its content is intended to be of a general nature, does not take into account your financial situation or goals, and is not a personalised financial adviser service under the Financial Advisers Act 2008. It is recommended you seek advice from a financial adviser which takes into account your individual circumstances before you acquire a financial product. If you wish to consult an ANZ Business Specialist, please contact us on 0800 269 249.