Ratios Making Sense of your Numbers
How to Make Sense of Your Financial Statements
Often when I show a client a financial report, they respond with a blank stare. When I point out a figure in the report, such as their net profit, they may ask something like: “is that good?”.
They are appropriate responses because numbers can seem meaningless on their own. Only when they are put into some context do they become useful, which is where ratios come in.
Is that a good profit?
A ratio compares the relationship between more than one number, giving them context. For example, the net profit margin is the percentage of your revenue (or sales) left after deducting all your business expenses. It is important because it shows how efficiently you turn your revenue into profit.
If your financial statements show a net profit of $80,000 and revenue of $400,000, your net profit margin is 20% (80,000 / 400,000 x 100%).
To put it another way, your net profit is your revenue multiplied by your net profit margin. The higher the margin the more of your revenue you keep:
Net Profit = Revenue x Net Profit Margin
($400,000 x 20% = $80,000).
Using ratios, we now have a measure that we can put into context.
Meaning comes from comparing
If your revenue had been $500K instead of $400K, but your net profit margin only 15% instead of 20%, you would have only made a profit of $75K ($500,000 x 15% = $75,000). So, focusing on growing fees without maintaining margin is no use. You can be working a lot harder for less money.
So, is our 20% net profit margin good? The best indicator is a comparison to other businesses in the same or a similar industry. If we are an independent consultant, comparing our $80,000 net profit with a top four consulting firm would be meaningless – and depressing – but comparing our net profit margin is useful.
Taking our 20% net profit margin, if others in our industry are achieving 13%, we are very efficient. Maybe we have lower overheads, or we are focused on high margin services while they cover a wider range.
Benchmarking figures are available from various sources for different industries and can be sliced and diced into regions, business sizes etc to get meaningful comparisons.
By comparing our ratio with previous years, we can see if we are getting better or worse.
By comparing our ratio with our budget, or target figures, we can see if we are heading towards our goals and budgets or not.
Good decisions are based on good management information and our ratios will reveal where we can concentrate our efforts to achieve the most dramatic impacts on our results.
Let’s look at another couple of examples.
Paying the bills
It is one thing to make a profit, but it’s no use until we collect it. Profitable, growing businesses still collapse when they can’t collect it quickly enough to pay their bills.
The current ratio is a measure of our ability to pay our bills. It compares our current assets (money we will collect in cash in the short-term) with our current liabilities (money we will have to pay out in the short-term).
Our current assets include money in the bank and debtors. Current liabilities include creditors, upcoming tax payments and other short-term financial obligations. The current ratio shows us how much we have in current assets to cover our current liabilities. I.e., how much money we have coming in to pay our bills.
Current Ratio = Current Assets / Current Liabilities
If our financial statements show current assets of $45,000 and current liabilities of $45,000, we have a current ratio of 1. Whether this is good or not depends on the industry we are in.
A supermarket can survive on a low current ratio as they have a plentiful supply of cash sales coming in each day. A consultant may need a much higher ratio. It takes time to deliver services, get them invoiced, then collect the money. While some businesses may be comfortable they can pay their bills with a current ratio under 1, a consultant may need a ratio over 2.
Getting new clients
Ratios can be used to measure all parts of our business, not just our financial results. To grow our client base, we need to convince people who are interested in our services to become clients. The rate of turning these leads into clients is our conversion rate.
Conversion Rate = No. of Sales / No. of Leads x 100%.
If ten people enquire about our services, and two of them become clients, we have a 20% conversion rate (2 / 10 x 100%).
If we are generating plenty of enquiries but few new clients, improving our conversion rate will have a big impact on our results. We may need to work on our sales pitch.
If our conversion rate is high, concentrating on generating more leads will bring us many more clients. We may need to increase our marketing efforts.
Using ratios effectively
The first step to improving business performance is getting meaningful information that shows us where our business is at now. Armed with this information, we can understand what needs to change for the biggest impact on our results.
There are unlimited potential measures but the fewer we focus on the more energy we can put into changing them. A good business dashboard may contain four different measures covering four different parts of the business.
As management accountants, we help you take your business beyond guesswork and focus your efforts where they will get the greatest return.
Contact us with your business questions.