Financial Ratios and How They Drive the Bottom Line
Posted on 11th August, 2017
For most small business owners their financial reporting analysis doesn’t stretch far beyond looking at the balance of their bank account. However, good cash flow management stems from a healthy Balance Sheet and a Profit & Loss statement in the black. In fact, and at risk of sounding like a real bean counter, a Cash Flow Statement is actually produced by blending all of the debits and credits in a Balance Sheet and Profit & Loss Statement. So, it’s not rocket science then to decipher that to ensure cash flow remains king you need to understand and drive the factors that contribute to healthy financial statements.
This is all starts with knowing and understanding the Financial Ratios of your business. So, what are Financial Ratios? Think of your business as a cake and each slice taken from your cake makes up a certain percentage and when all but one slice remains that’s all yours to eat. If you think of a businesses total sales as the entire cake, the cake is typically made up of several main slices being Direct Costs, Productivity Costs and Operating Costs. Whatever is left at the end is your Net Profit (that’s your slice to eat).
We strongly believe in measuring and monitoring your Financial Ratios. You should frequently be comparing your annual, quarterly and monthly ratios and comparing them to not only your own businesses previous financial year (ensuring you compare the same periods so you are comparing apples with apples – this is especially important for seasonal businesses) but also comparing your ratios to industry benchmarks to ensure you have a competitive advantage over your competition.
Whilst all businesses are unique there are a few key indicators we focus on with our clients:
Sales Growth Margin – Quite self-explanatory this measures the pace at which your sales are growing. Ultimately this is where increased profits start because without the top line the bottom line cannot proportionately grow as well
Gross Profit Margin – This is the ultimate measure of a business’s efficiency – it measures how well your business is able to turn a direct cost of material or supplies and generate a revenue dollar from that. If your GP Margin is too low several factors generally include your sales prices being too low, supplier prices being too high, stock wastage and for say hospitality industries portion sizes being too big.
Rent Margin – This is your rent as a percentage of sales and this is typically a useful tool to determine your sales capacity in a premises from which you operate. If your rent margin is too high it typically suggests either your rent is too expensive or you are not utilising the space to full capacity and should be generating more sales (or a combination of both)
Wages Margin – This is ultimately your productivity test to determine if your staff are driving the sales of the business. If your margin is too high is would typically signify either underperforming staff or a problem with your sales prices
Operating Cost Margin – This measures all of the other operating costs of your business. If your operating cost margin is too high then a cost cutting exercise should always be undertaken
Net Profit Margin – This is your bottom line, so if all of the margins above are as and where they should be then the Net Profit Margin you are targeting should be achievable (and that’s your slice of the cake to either take as the profit or reinvest into the business to drive further growth)
Current Ratio – Finally, this is a measure of a business’s solvency (if it can satisfy its debts as and when they fall due). In this ratio we take the Current Assets of the business (typically Cash, Trade Debtors and Stock) and measure them as a ratio over the Current Liabilities of the business (typically Overdrafts, Credit Cards, Trade Creditors, GST, PAYG-Withholding and Superannuation). Rule of Thumb is that to maintain good cashflow the assets should be 2:1 over the liabilities.
Constantly measuring the above margins is vital in getting a good in depth understanding of what is happening in your business and plays an important role in being able to make good, proactive and significant business decisions to ultimately increase your bottom line.