Your Financial Phrase
One could fill a book with details of financial ratios, along with a glossary of terms used by accountants and finance professionals. Tat is not going to happen here. However, no self-respecting guide for entrepreneurs would be complete without a mention of some of the key ratios and phrases that are used by investors, advisors and even by entrepreneurs themselves to describe the performance and characteristics of their businesses.
Here are some of the main ratios:
•Current Ratio. Tis measures your current assets against your current liabilities and is a good indicator of solvency, in this case defined by a business’ ability to pay its debts as they fall due. Te ratio is expressed as the number of times current assets exceed current liabilities. A high ratio tends to indicate financial strength, whereas a number of less than one means that current liabilities exceed current assets, regarded as a generally unhealthy indicator.
•Quick Ratio (also known as Acid Test). Tis ratio measures your current assets, excluding
stock, against your current
liabilities. Because of the exclusion of stock from the calculation, it broadly measures the
relationship between your debtors,
your creditors and your bank balance. In the absence of unusual circumstances, a number greater than one normally indicates financial strength.
•Gearing Ratio. Measures the long term liabilities of the business, such as loan capital or other debt, against the shareholders’ equity. Te higher the ratio, the more dependent the business is on external debt and the more vulnerable it is considered to be.
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•Return on Capital Employed. Tis represents the percentage profit earned on total shareholders’ equity. For this purpose shareholders’ total equity (ie including accumulated profits and reserves) is used, not just the basic share capital. Te profit used in the calculation is normally net profit before tax or EBIT (Earnings before interest and tax- see later).
•Debtor Days. Tis ratio is intended to show how many days sales are outstanding at any one time. It can be calculated by measuring the debtors against the annual sales and then multiplying the percentage result by 365. Alternatively a ‘count back’
•Stock Turnover. Te stock turnover ratio indicates how many times the stock in the business is being turned over on an annual basis. It is calculated by dividing the cost of sales by the average stock balance. Note
•Gross Profit Margin. Te gross profit ratio is commonly used and widely understood. By dividing the gross profit by the sales, the ratio provides the percentage of profit on sales, aſter deducting the direct costs of those sales, but before deducting other overheads. In money terms, gross profit is the amount available to pay the overheads, so if gross profit exceeds overheads, then an overall ‘net’ profit arises.
•Net Profit Margin. Te net profit margin is calculated by dividing the net profit by the sales and shows the percentage of profit earned on sales aſter deducting all direct costs and overheads.
method can be used, whereby debtors are deducted from the most recent months sales first, then the previous month and so on, until the debtors have been ‘used up’. Te number of months it takes to use the debtors then gives a result, such as 2.5 months, or approximately 75 days.
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