What are financial ratios?
Financial ratios are extremely useful indicators of your business’s financial performance and its financial situation. The information used to calculate financial ratios is typically contained within your management accounts, meaning that your Bookkeeper can present the results of the ratios to you each month. By understanding the information that financial ratios provide, you can apply their results to the management of your business and to decisions that you make.
Benefits of financial ratios
There are many financial ratios to choose from, meaning that there are ratios that will provide you with valuable information with which to manage your business, regardless of which market your business is in.
Financial ratios allow for comparisons:
- between companies
- between a company and its industry average
- between industries
and they also allow you to analyse trends within your business by comparing their results over a period of time.
Below are just 5 of the many financial ratios that you could apply to your business.
1. Gross Profit Percentage
The Gross Profit Percentage shows how much of every Rand of income a business really has after its cost of sales is taken into consideration. The higher the percentage the better, given that the business’s gross profit has to cover all of the business’s overheads (expenses) before the monthly profit is arrived at.
2. Net Profit Percentage
The Net Profit Percentage shows how much of each Rand of income the company keeps after meeting its costs. The higher the percentage, the better. Importantly, this percentage is the greatest discount that a company can give without incurring a loss.
3. Current Ratio
The Current Ratio shows how many times the company could pay its present debts if it applied all of its current assets. A value of 2 is ideal.
4. Sales To Receivables Ratio
This ratio measures the time between sales and debt collection – in other words the business’s credit control. The higher the result of this ratio, the shorter the time between sales and debt collection. So, a high value indicates that clients tend to pay within a month of being invoiced, or that a business’s allocation and collection of credit is efficient. However a low value points to the business having to re-assess its credit policies.
5. Working Capital
Although referred to as a financial ratio, this ratio is not actually a ratio! The result is a value in Rands, showing the amount of money that a business has tied up in funding its day to day operations. A value that increases over time is sought. Working capital is used by potential Investors or lenders in order to gauge the ability of the business to get through difficult financial periods
Financial ratios will help to determine your business’s financial health over time and to compare its performance with companies in the same line of business. Trade Magazines, Chambers of Commerce and the Internet are good places to find this information for listed companies.
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