How is your business performing? Your answer should be based on rock-solid data and figures. We get it. Crunching the numbers and using financial ratios isn’t the exciting part of your business. Yet it’s how you check that your business is financially healthy, rather than growing in the dark.
Financial ratios commonly fall into four groups. Profitability ratios show how much profit you make from your sales and capital. Debt ratios show how the business is funded and how much risk that carries. Liquidity ratios show whether you can pay your bills in the short term. Efficiency ratios show how well you use your stock, debtors, people and assets.
A few ground rules before the formulas. Take all figures from the same period and the same set of accounts (profit and loss figures for a period such as a financial year, balance sheet figures at the end of it, or averages across it). Use Australian dollars. Revenue and cost of sales should exclude recoverable GST. Match the GST basis of sales and debtors when calculating receivables turnover. For current and debt ratios, use correctly prepared balance-sheet balances, including tax liabilities; do not strip GST from every balance. And treat benchmarks with care: a “good” ratio varies widely by industry, business model and season, so your own trend over time, and comparison with similar businesses, is more useful than any universal rule.
Profitability ratios
These ratios show your company’s ability to bring in profit:
1. Gross profit margin
Gross profit margin is the share of each sales dollar left after the cost of goods sold (or, for a service business, the direct cost of delivering the work), before overheads. It shows whether your pricing covers your direct costs with enough left over to pay your other expenses and still make a profit.
Gross profit margin = (Sales − Cost of goods sold) ÷ Sales × 100 = Gross profit ÷ Sales × 100
Example: sales of $1,000,000 and cost of goods sold of $600,000 give a gross profit of $400,000 and a gross profit margin of 40%.
2. Net profit margin
The net profit margin is the percentage of sales remaining after all expenses, including cost of goods sold, overheads, interest and income tax. Some businesses use net profit before tax instead, which makes comparison easier between sole traders, trusts and companies; just be consistent.
Net profit margin = Net profit after tax ÷ Sales × 100
Example: net profit after tax of $60,000 on sales of $1,000,000 is a net profit margin of 6%.
3. Operating profit margin
Operating profit margin shows how much of each sales dollar is left after the costs of running the business, before interest and tax. A higher ratio usually points to better pricing, cost control or both.
Operating profit margin = (Gross profit − Operating expenses) ÷ Sales × 100
Example: gross profit of $400,000 less operating expenses of $300,000 is an operating profit of $100,000, a 10% operating profit margin on $1,000,000 of sales.
4. Return on equity
Return on equity shows the after-tax return the business earns on the owners’ (shareholders’) equity. Averaging opening and closing equity gives a fairer result if equity changed during the year.
Return on equity = Net profit after tax ÷ Shareholders’ equity × 100
Debt ratios
These ratios show how much the business relies on borrowed money and whether it can carry that debt.
1. Debt to asset ratio
The debt to asset ratio is the share of your total assets funded by liabilities rather than by the owners. A high ratio means more of the business is funded by creditors, which increases financial risk.
Debt to asset ratio = Total liabilities ÷ Total assets
2. Debt to equity ratio
The debt to equity ratio compares what the business owes with what the owners have invested and retained. A ratio of 1 means liabilities equal equity; the higher the ratio, the more the business relies on borrowed funds. Lenders often look at it when assessing a loan.
Debt to equity ratio = Total liabilities ÷ Shareholders’ equity
(Lenders often use interest-bearing debt only, excluding trade creditors, GST and leave provisions; check which version your lender means.)
3. Times interest earned ratio
The times interest earned (or interest cover) ratio shows how many times your operating profit covers your interest costs. The higher the ratio, the more comfortably the business can meet its interest payments.
Times interest earned = Earnings before interest and tax (EBIT) ÷ Interest expense
Example: EBIT of $100,000 and interest expense of $20,000 gives interest cover of 5 times.
Liquidity ratios
Liquidity ratios indicate your company’s ability to meet short-term debt obligations without raising extra capital.
1. Operating cash flow ratio
This ratio compares the cash your operations generate with your current liabilities. It shows how well day-to-day trading covers the bills falling due in the next 12 months.
Operating cash flow ratio = Net cash flow from operating activities ÷ Current liabilities
A ratio below 1 means operating cash flow for the period didn’t cover current liabilities, so the business is relying on cash reserves, borrowing or new funding to pay them. That is a warning sign worth investigating, especially if it persists, though seasonal or fast-growing businesses can dip below 1 for a time.
2. Current ratio
The current ratio shows whether your current assets cover your short-term (or current) liabilities. It’s a more reliable guide when your stock and debtors can be turned into cash quickly.
Since current assets and liabilities are short-term, you expect to turn those assets into cash and pay off those liabilities within a year.
Current ratio = Current assets ÷ Current liabilities
Example: current assets of $300,000 and current liabilities of $200,000 give a current ratio of 1.5.
3. Quick ratio
Also known as an “acid test,” a quick ratio is similar to the current ratio but excludes inventory and prepayments, which cannot be turned into cash. It’s a useful test where stock is hard to turn into cash quickly. A ratio of about 1 is often used as a rule of thumb, but what’s healthy varies by industry.
Quick ratio = (Current assets − Inventory − Prepayments) ÷ Current liabilities
Example: if $120,000 of the $300,000 in current assets above is stock and prepayments, the quick ratio is $180,000 ÷ $200,000 = 0.9.
Operational efficiency ratios
Operational efficiency ratios show how well the business uses its stock, debtors, people and assets. You work them out using figures from both your profit and loss statement and your balance sheet.
1. Inventory turnover
Inventory turnover shows how many times you sell through and replace your stock in a period. Higher usually means stock moves faster; too low can mean cash is tied up in slow-moving stock.
Inventory turnover = Cost of goods sold ÷ Average inventory
To get average inventory, add the opening and closing stock balances for the period and divide by 2. Example: cost of goods sold of $600,000 and average inventory of $100,000 is a turnover of 6 times a year, or roughly every 61 days (365 ÷ 6).
2. Accounts receivable turnover
Accounts receivable turnover indicates how you’re managing your collections. A high figure usually shows that clients are settling their debts quickly.
Accounts receivable turnover = Net annual credit sales ÷ Average accounts receivable
To determine average accounts receivable, add starting to ending receivables over a period and divide by 2.
Trade debtors on your balance sheet include GST, so divide the debtors figure by 1.1 (or gross up credit sales by 10%) before calculating; otherwise debtor days are overstated by about 10%.
3. Revenue per employee
You need to know your employees’ efficiency and productivity levels. A revenue per employee ratio helps you ensure that you’re managing your workforce efficiently. And benchmarking the figure against similar firms is recommended.
Revenue per employee = Annual revenue ÷ Average number of employees in the same year
Counting full-time equivalent (FTE) employees rather than headcount gives a fairer comparison if you have many part-time staff.
4. Return on total assets
This ratio shows how efficiently the business uses its assets to generate profit.
Return on total assets = Net profit ÷ Average total assets × 100
To determine average total assets, take the sum of starting and ending assets over the year and divide it by 2.
5. Average collection period (or debtor days)
The average collection period estimates how many days, on average, your customers take to pay you.
Debtor days = 365 ÷ Accounts receivable turnover = (Average accounts receivable ÷ Net credit sales) × 365
Where net credit sales = Credit sales − Sales returns − Sales allowances.
Example: net credit sales of $1,200,000 and average accounts receivable of $150,000, both on the same GST basis, give a receivables turnover of 8 and debtor days of about 46 (365 ÷ 8). If your payment terms are 30 days, that gap is worth chasing.
Let Visory handle the calculations
Financial ratios give you a snapshot of your business’s health at a point in time, and tracked month by month they show the trend. You (the business owner), lenders and investors use them to make decisions, and they are only as reliable as the books behind them.
But if your plate is already packed full with other equally crucial tasks, you need a helping hand. That’s where Visory steps in.
Visory runs bookkeeping, payroll, accounts payable and receivable for growing businesses, with a dedicated team and our AI, Delphi, overseen by that team. With Visory Insights, a Business Performance Partner walks you through a plain-English monthly read of the numbers, so you can get back to big-picture business growth.
About this article
Written by The Visory Team. Published . General information for Australian businesses, not advice for your situation.
