There are a number of different ratios that can be used by companies to help them measure and analyse their performance. The ratios are often compared to previous year’s performance as well as the average results for your industry. This can then be used to measure how well you may be doing in different aspects of your business. There are 5 different categories of ratios that each ratio falls under. These are: profitability ratios, market ratios, debt ratios, activity ratios and liquidity ratios.
Profitability ratios are probably the most commonly used ratios, they measure how a company would use its assets and how it controls its expenses to produce a good rate of return. Market ratios are used to show the return on investment for the business. They are often used when trying to sell a business to show potential investors that the company is worth buying into and will be profitable. Debt ratios are often used to measure how quickly a business can pay off any long tern debts, for example a bank loan or mortgage. Activity ratios are used to measure whether a business is getting the most out of their resources and also whether their cash is being utilised. Liquidity ratios are used to measure whether a business is capable of paying of their debts, for example a business may have a lot of cash in the bank but if their liabilities are higher than their assets then their company is not liquid.
You do however need to be careful when using any single ratio as it will never give you the full picture of how well your business may be doing. An example of how this may happen is if you use the gross profit margin ratio and compare it to the net profit margin ratio.
A simple example of this is shown below.
Looking at the results above you can see two very different results but they are both correct so must be used correctly. If for example you had set a target at the beginning of the year to make a 25% profit. If you were to use the gross profit margin you can see that the profit you have made would be 30% which is great as it looks like you have beaten your target. However as you are able to see this doesn’t show you the full picture as the 30% doesn’t include any of your expenses. When you take your expenses into account you can see that your profit margin falls to only 5%.
Another ratio that is good to use is the current ratio (also known as the working capital ratio). This is one of the basic liquidity ratios as it simply uses the company’s current assets to see if they would be able to cover their current liabilities. An example of this is shown below:
As you can see in this example the company’s current ratio is 2.0. This means that for every £1 of liabilities that they have, it is covered by £2 worth of assets. A common rule of thumb that is used is that if you have at least a 2.0 current ratio your company is often in a good position.