12.05 – Analysing Financial Performance
Gathering and recording financial information leads to analyzing how well (or poorly) a business is performing. This analytical process requires tools, specifically ratios, to understand their usefulness and limitations before applying them effectively.
Using Ratios
All financial analysis involves comparisons. Because a business is constantly changing, the most useful way to measure activity is through ratios. A ratio is simply one number expressed as a proportion of another. For instance, traveling 100 miles might not sound impressive until you realize it took one hour, resulting in a ratio of 100 miles per hour. Similarly, in finance, ratios can transform raw data into valuable information and guide decision-making. Key financial ratios to monitor at least monthly are described in the following sections.
Gross Profit Percentage
To calculate the gross profit percentage, deduct the cost of sales from the sales and express the result as a percentage of sales. The higher the percentage, the greater the value added to the goods and services produced.
Gross profit percentage formula:
Gross Profit Percentage = (Profit / Sales − Cost of Sales) × 100
Operating Profit Percentage
Calculating the operating profit percentage measures how well the management is running the business. Operating expenses, which management is responsible for, form part of the calculation. Financing decisions are typically the owner’s responsibility, and interest and taxation are set by the government, so those numbers are excluded from management control and accountability.
Operating profit percentage formula:
Operating Profit Percentage = Profit / {Sales − (Cost of Sales + Cost of Operations)} × 100
Net Profit Percentage
Net profit indicates the business’s bottom line, showing how much money is left for reinvestment or distribution. A higher percentage means more money from each pound of sales.
Net profit can be calculated after tax or before – known as EBIT (Earnings Before Interest and Tax).
Net profit percentage formula:
Operating Profit Percentage = Profit / {Sales − (Cost of Sales + Cost of Operations + Taxes Paid)} × 100
Return On Capital Employed
ROCE, frequently abbreviated, is a primary performance measure for businesses. For example, if you invested £10,000 in a bank and earned £500 in interest at the end of the year, the return on your capital is 5%.
A business calculates ROCE by expressing the operating profit as a percentage of the total capital employed, including fixed assets and working capital.
ROCE formula:
ROCE = Operating Profit / (Fixed Assets + Working Capital) × 100
Current Ratio
The current ratio is calculated by dividing current assets by current liabilities. The ideal ratio is as close to 1:1 as the safe conduct of the business allows. This varies by industry; for example, a retailer might operate safely at 1.3:1, while a manufacturer might need over 2:1 due to longer cash flow cycles.
Average Days’ Collection Period
The average collection period ratio, calculated by dividing the value of debtors by the value of credit sales and multiplying by the days in the period, helps businesses understand how quickly customers are paying their invoices. A 60-day period is normal, 45 days is a good target, and 90 days is too long.
Stock Control Ratio
The stock control ratio indicates how many times a business turns over its stock each year. Dividing the cost of sales by the value of the stock provides this ratio. The more frequently stock is turned over, the more profitable the business.
Gearing down
Gearing measures the proportion of borrowed money to shareholders’ funds. Highly geared businesses can be vulnerable during economic downturns or rising interest rates.
Gearing percentage formula:
Gearing Percentage = Debt (Long-term Borrowings) / {Debt + Shareholders’ Funds} ×100
Gearing levels in small firms typically range from 30% to 60%.
Useful Tools for Business Calculations
- Bankrate.com: Offers several free small-business ratio calculators covering various aspects of measuring financial performance (Bankrate).
- Ready Ratios: Provides online software for a complete financial analysis of accounts, including over 40 ratios, tables, diagrams, and summaries (Ready Ratios). The basic system is free, and a year’s subscription to the Master service is around £150.
Using these ratios and tools helps transform financial data into actionable insights, guiding better business decisions.
