Using key financial ratios to assess performance of your business

In the previous article we discussed how a business leader can use liquidity and solvency ratios to assess the performance of a business. The other key ratios that can be used are those ratios that show the profitability, efficiency and investment potential of a business.
Profitability ratios indicate how a business is performing in terms of its ability to generate profit.

These ratios show how well a business is achieving profits from its operations. The profitability ratios focus on a business’ return on investment in inventory and other assets in order to judge whether it’s making enough operational profit from its assets.
Some of the key ratios that entrepreneurs, investors and other financial analysts consider when judging how profitable a business should be are gross profit margin, net profit margin, return on assets, return on capital employed and return on equity.
The gross profit margin compares the gross profit of a business to the net sales. Gross profit is the net sales less cost of goods sold and it’s that profit that goes to pay for operating expenses.

The ratio measures how profitable a business is selling its inventory and it’s calculated by dividing gross profit by net sales.
A business should aim to have a higher ratio because it means it will be able to cover its operating expenses and in turn make a net profit.
The net profit margin measures the amount of net income earned with each dollar of sales generated. It shows what percentage of sales are left over after all expenses are paid by the business.

The net profit margin is calculated by dividing net income by net sales. This ratio is very important because it measures how effectively a company is converting sales into net income.
Investors would want a high net profit margin because this will ensure that there is enough profits to cover for dividends and for reinvesting into the business. This will show that the company is running efficiently. If the ratio is too low it would indicate that the expenses are too high and management should manage, control or cut the expenses.
Net profit margin is affected by declining gross profit, increasing or falling selling price or rising or falling administration costs. It’s advisable to look at the trend and see how this ratio has been behaving.

The return on assets ratio (ROA), or return on total assets, is a profitability ratio that measures the net income produced by total assets during a period.
The ROA measures how efficiently a company is managing its assets to produce profits during a period. The ROA ratio is calculated by dividing net income by average total assets.
The higher the ratio the more favourable it is to investors because it shows that the company is effectively managing its assets to produce net profits.
ROA is most useful for comparing businesses in the same industry since different industries use assets differently.

The next set ratios measure how efficiently the business is being run. Some of these ratios are debtors’ days outstanding, asset turnover and inventory turnover.
The debtors days outstanding calculation, or the average collection period, measures the number of days it takes a business to collect cash from its credit sales.
This calculation shows the liquidity of the business and the efficiency of a business’s collections department.

If the business can collect cash from debtors earlier it will improve the liquidity of the business and will release cash for use in other business operations.
The debtor’s days outstanding ratio is calculated by dividing the ending accounts receivable by the total credit sales for the period and multiplying it by 365 days.
The debtor’s days outstanding shows investors and banks how well a business can collect cash from its customers by showing number of days it takes a company to convert its sales into cash.

A lower number of days is more favourable because it means companies collect cash earlier from customers and can use this cash for other operations.
The next efficiency ratio is the asset turnover ratio which measures a business’s ability to generate sales from its assets by comparing net sales with average total assets.
The asset turnover ratio shows how efficiently a business can use its assets to generate sales. If a company has a ratio of 0.5 it means that each dollar of assets generates 50 cents of sales.
A higher ratio is more desirable because it means the company is using its assets more efficiently.

Like with most ratios, the asset turnover ratio is based on industry standards so to assess the performance of a business the ratio must be compared with other companies in its industry and with a trend.

The last of the efficiency ratios is the inventory turnover which shows how efficiently inventory is managed by comparing the cost of goods sold with average inventory for a period. The ratio measures how many times inventory is sold or turned during the year. Thus the ratio measures how efficiently a company is controlling its stocks.

The aim should be to have a high turnover ratio because if a company can turn its inventory many times it means it’s making sales from its stocks rather than holding too much stocks thereby incurring storage and other stock holding costs.
This ratio also shows that the business can effectively sell the inventory it buys and also that the company’s inventory is liquid, that is, it’s being turned into cash fast. Inventory turnover ratio is also vary with the type of industry.

I will continue with the ratio analysis in the next article.
Stewart Jakarasi is a business & financial strategist and a lecturer in business strategy and performance management. He provides advisory and guidance on leadership, strategy and execution, preparation of business plans and on how to build and sustain high-performing organisations.

l For assistance in implementing some of the concepts discussed in these articles please contact him on the following contacts: sjakarasi@gmail.com or +266 58881062 or on WhatsApp +266 62110062