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Key Financial Ratios Made Easy

 Nick Roberts

In today's modern world where we are time-poor, multi-tasking and on-call 24/7 (thanks to so-called Smart Phones!) it's easy to forget some of the basic principles of financial life so essential to business. One such important area is key financial ratio's which are very useful in giving warning of impending financial disasters, so let's look briefly at the most important.

Current Ratio. Measures liquidity by dividing current assets by current liabilities. Traditionally current assets should be twice current liabilities, expressed as 2:1. Anything worse than 1:1 means you're insolvent and heading for trouble e.g. 1:2.

Quick Ratio. A more accurate measure of liquidity arrived at by dividing current assets excluding stock by current liabilities, as stock would obviously take a while to dispose of.

Gross Profit Margin. The key measure of profitability (and unlike other profitability ratios harder to manipulate), this shows you how much profit you're making on your sales prior to fixed costs. Divide your gross profit by your sales.

Net Profit on Sales. Much harder to compare in SME's because of the level of owner's remuneration and those who buy themselves a job but a good business should be making a 20% profit on sales after all costs including tax. Divide your net profit after tax by your sales.

Net Profit on Capital Employed. Useful in deciding whether the business is worthwhile. Taking into account the risks in business, a business needs to be returning substantially more than any passive investment, otherwise why bother? To calculate divide your net profit by the capital employed in your business.

Now of course just working out your key financial ratios is not enough, you have to use them to manage your business, so work these out regularly to be able to see the trends. Are they getting better or worse? In addition, use benchmarking (any modern accountant will have access to these) to compare yourself with your peers. Lastly, have a good think about the performance of your business. If this is not rosy perhaps it's time to retire or accept reality that business life has changed substantially in recent years and that it is time to up skill on marketing, get some decent financial systems and find an accountant who does more than just your annual financials and tax!

If you have any tax or business queries of any kind telephone 0800 ASK NICK, e-mail me at nick@abac.co.nz or use "Contact Us" on www.abac.co.nz. The information in this article is of a general nature and should not be relied upon as a substitute for specific advice.

 
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