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Business Finance Consultants

Financial Ratios – Efficiency Ratios

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In an earlier blog (Financial Ratios – Profitability Ratios), I spoke about the importance of Profitability Ratios. In this blog, I highlight the importance of Efficiency Ratios.

In simple terms, Efficiency Ratios measure how well companies utilise their short term assets and short term liabilities to generate income. Efficiency ratios, for example, might include the time it takes for companies to collect cash from customers, how quickly or slowly they pay their suppliers and the time it takes to convert inventory into revenue.

While Efficiency Ratios are generally used by management to help improve the company, they are also often used to inform outside investors and creditors of the operational performance of the company.

Let’s consider a couple of examples of Efficiency Ratios:

Debtor Days tells you how many days it takes for the money to reach your bank account after you have issued invoices. The lower, the better. A decrease in the ratio is good; an increase should be regarded as an alarm bell.
Debtor Days = Debtors (Net of GST) / Annual Sales x 365

Creditor Days represents the average time that a business takes to pay its Creditors. The higher, the better.
Creditor Days = Creditors (Net of GST) / Annual Cost of Goods Sold x 365 Read more →

Business Finance Consulting

Financial Ratios – Profitability Ratios

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A recent article in the Australian Financial Review explained that the three main reasons for business failures were: Poor Financial Management (28% of failures), poor Accounting (16%) and lack of Management experience (15%).

So Poor Financial Management is the main culprit in business failures. The Directors and the owners of a company need to monitor the financial performance of the business. Revenue, Gross Profit, Operating Profit are important elements, but they have limitations: Firstly, they vary considerably with the ups and downs of Revenue (seasonality), and secondly, an increase in Operating Profit does not always reflect good performance (if Operating Profit increases by 5% for example, while Revenue increases by 20%, it is a poor result).

Ratios do not have these limitations and that is why they are widely used to measure financial performance.

Let’s look at the first set of financial ratios: The Profitability Ratios.

Profitability ratios measure the business’ ability to generate profit as compared to its costs and expenses, over a period of time.

They are: The Gross Profit Ratio, the Operating Profit Ratio and the Profit Before Tax Ratio. Read more →

Business Finance Consulting

It’s Payback Time! …or is it?

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Everyone facing a business investment decision, such as launching a new product, purchasing equipment, installing a new production line, building a factory or acquiring a business needs to ask themselves the following questions:

How long before I get my money back?
Which of these investments is better?

The Payback Analysis provides us with a means to answer these questions by clarifying the length of time (weeks, months or years) required for an investment to reach breakeven, before it begins returning a profit. This length of time is called the Payback Period.

The calculation takes into account Incomes, Expenses (*) and Taxes. The shorter the payback period, the better. The longer the payback period, the longer funds are locked up and the riskier the project.

Read more →

Stocktake

Doing A Stocktake Is In Your Interest!

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The end of Financial Year approaches and most businesses would typically be planning and organising their annual stocktake. Other companies may do one or several interim stocktakes during the year in order to better monitor their inventory and/or minimise the disruption of a full stocktake.

A stocktake is the verification of the items physically held in inventory (also called stock). Both the quantity and the condition of each item are checked. The purpose of a stocktake is to confirm that the real physical inventory of a company reconciles with the theoretical inventory held in the accounts.

The objectives of a stocktake are multiple:

  • To remove the items that are broken, damaged or that have become obsolete;
  • To learn of items that are no longer there;
  • To provide valuable information on slow moving items;
  • Last but not least, to reduce your taxable profit via inventory write-offs.

You would not want to pay taxes on a profit you did not make, would you?

Inevitably, a stocktake will end up with a list of discrepancies: Items unaccounted for, missing or that reduced in volume, density, quality, etc. Even the best companies with well implemented inventory procedures will have discrepancies: It is human nature or should I say it is “business nature”. Read more →

The Real Impact of Giving Discounts

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As a consumer, we all love to receive discounts when we purchase. The same goes when buying goods or services for our company.

But discounts have a strong impact on the business and its Gross Profit (also called ‘Gross Margin’):

  • Discounts received trigger:
    • Increase in Gross Profit
    • Increase in Profit before Tax
  • Discounts given can trigger:
    • Loss or Revenue
    • Loss of Gross Profit
    • Decrease of Profit before Tax

So if you intend to give a discount to your customers, the question becomes: How much increase in Revenue do I need, in order to maintain the Gross Profit in $ value?

The answer is in the following formula:

= [(Gross Profit ratio / (Gross Profit ratio – % Discount given)) – 1] x 100

If it sounds complicated, here is a table with all calculations already done: Read more →