In order to make better business decisions, you need to understand your financial performance and the operational and financial implications of those decisions.
Do you have sufficient cash-flow?
Can you endure temporary shut-down or slowing of payments from your customers?
How does your profit margin compare with your competitors?
What gets measured gets managed so it is important to periodically review financial ratios like liquidity, profitability and leverage to measure the health of your business.
The ATO app has a business performance check feature which compares cost of sales and expenses to revenue using business benchmarks that are updated annually. This is useful to compare your business to others in your industry but is limited when it comes to liquidity and leverage which are critical if your business uses any form of finance or supplier credit.
Liquidity ratios reveal how easily a business can pay its debts. An important measure for any business that has suffered a shut-down or decline in revenue during COVID-19 pandemic, or for any business owner that wants to manage risk during uncertain times. Examples of liquidity ratios include the:
- Quick Ratio, an indicator of a business’s ability to use cash to meet its short-term obligations without disposing of assets.
- Current Ratio measures how much of a business’s assets can be converted into cash over a 12-month period to pay debts which need to be paid during the same time frame.
For both of these examples a high ratio result demonstrates a healthy financial position while a low result indicates a risk that the business may struggle to pay its debts.
Profitability ratios are a point in time measurement of a business’s ability to generate profit relative to its turnover and are used to assess a business’s profit margin, return on assets and return on equity. Corporations often report to their shareholders using EBIT (earnings before interest and taxes) or EBITDA (earnings before interest, taxes, depreciation and amortisation) while small business values Gross Profit, Operating Profit and Net Profit.
- Gross Profit = net sales minus the cost of goods sold
- Operating Profit = gross profit minus selling and administrative expenses
- Net Profit or “the bottom line” = operating profit plus any other income minus any additional expenses and taxes.
Leverage ratios assess the ability of a business to meet its financial obligations by comparing debt to equity, debt to capital and debt to EBITDA. A commonly used leverage ratio is the debt ratio which measures the percentage of a business’s assets that are paid for by debt. A business with $1 million in assets and $250,000 in debt would have a debt ratio of 25% showing it has more assets than debt whereas a business with $1 million in assets and $1.1 million in debt has more debt than assets.
Knowing when to measure what, and making sense of the information to inform business decisions is something that a quality bookkeeper or Accountant can assist with. Accurate Accounts is one provider that is super-qualified to help small businesses make sense of their management accounts and financial reports. To solve the financial mysteries of your business contact Elaine Wade at Accurate Accounts for personal and customised assistance. www.accurateaccounts.com.au