“Oh no maths! “~ you might think… but ratios are a big help in making sense of the financial numbers that you have and show a comparable indicator to enable you to make key decisions. The below are six key ratios you should include as your key performance indicator (KPI).
Net profit margin ratio
The profit margin ratio shows how efficient a company is at controlling costs as a percentage. A higher net profit margin indicates that the company is better at converting its turnover to actual profit. This ratio helps to make comparison with the industry standard and benchmark against other companies in the same industry to evaluate performance.
Debt to equity ratio
Debt is money borrowed by the company to run their operations. Shareholder’s equity refers to the money put in by the shareholders into the business. This ratio shows how the two are balanced. Generally, a high debt to equity ratio is not desired however also consider both the industry-wide trend and the company specific requirements.
This ratio indicates the liquidity of a company i.e. how easily the company can turn its assets to cash to meet its short term liabilities. 2:1 ratio is generally considered a good split. The higher this ratio, the higher the capability of the company to pay its liability. This ratio is also called as cash ratio, liquidity ratio or working capital ratio.
Return on Equity (ROE)
This ratio indicates how profitable the shareholder’s capital is in the business they have invested in. This ratio is expressed as a percentage and the higher this percentage the better the company is doing in generating profits.
This ratio indicates the number of days’ customers take to pay the company on average. A high number shows that the company must utilise and invest more cash for its working capital needs whilst a low number indicates that the company has cash available for other uses.
To analyse the debtor days correctly, consider other factors such as industry standard, discounts given by the company for early payment, if any - ensure this is considered in the calculation, credit practices by the company and the technological tools/trained staff that is used in the company's debt collection procedure.
Creditors days is the other side of the coin to “Debtors Days Ratio”. This ratio indicates if the company is taking advantage of the credit facilities available to it. It shows the number of days the company takes to settle its debts with their trade creditors. In an ideal situation, the debtor days should be less than the creditors days to maximise the cash flow of the company. However, this depends on the company’s negotiation power with customers and suppliers. Also the company should be aware of risks of late payment strategy such as late payment interest charges, threat of legal action or loss of goodwill/creditability with suppliers.