Why should you use ratios to make financial judgments?  Well, are you curious how well your business is doing financially? Or maybe you're looking to acquire or invest in a business and want to know what to look for? Ratios are a great way to judge a company's financial performance. In this weeks podcast I'll go over the most common ratios and what they mean for your business.

To be a successful business owner, you need to be able to judge your company's financial performance. One way to do this is by using ratios. Ratios can help you see whether your company is making money and growing or whether it's struggling.

In this podcast I'll explain what ratios are and how to use them to assess your business' financial health. Check out the I Hate Numbers You Tube channel to see a worked example. use these example ratios as a guide. So, if you're interested in learning more about ratios and how they can help you gauge your company's financial well-being, listen to find out more!

Conclusion

In order to make good financial decisions for your business you need to know how to use ratios to make financial judgments.  Whether you’re the one in charge of making them or advising those who are- it’s important that you understand how to judge performance. Ratios are a popular and accessible way to do this, but there are many different ways to look at finances. No matter where you stand on the spectrum of financial know-how, I hope this video has helped introduce you to the basics of ratio analysis and shown you how informative and valuable it can be when used correctly.

Check this link to learn more about financial statements.  I invite you to join my Numbers Know How Financial Story Plan Community. I’d love to have you there!

Check out my I Hate Numbers YouTube channel,  Subscribe to I Hate Numbers now so you don’t miss an episode.  My book, I Hate Numbers will change your relationship with numbers and money, in a good way.  Check out what people have said, buy the book and make your own mind up, you won’t be disappointed.

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There are many ways and many reasons why you may wish to judge financial performance. It could be your own business. You could be an investor looking at an opportunity. You can be looking at your competitors. Above all, you will want to know how you are doing, how well you are performing, where the challenges are not only in your business, but your competitors, your potential investment. And one of the most common techniques used to make these financial judgements is using a technique called financial ratios.

In this podcast, I'm going to continue from where we left off from last week. I'm going to dive deeper and look at the four areas of financial ratio analysis. Actually look at some specific metrics or ratios or measures that we can adopt, go through how each one is constructed, looking at potential interpretations. And by the way, folks, numbers are a bit of a challenge to do on a podcast. So for that reason, I'm going to enter in a show link to a worked example, a visual on my related YouTube channel, I Hate Numbers.

You're listening to the I Hate Numbers podcast with Mahmood Reza. The I Hate Numbers Podcast mission is to help your business survive and thrive by you better understanding and connecting with your numbers. Number love and care is what it's about. Tune in every week. Now, here's your host, Mahmood Reza.

Hi, folks. Welcome to another weekly podcast episode on I Hate Numbers. This is the podcast that's got a mission to improve your financial awareness, help you win more battles than you lose for that what goes on between your ears, help you and your business make more money, help you save tax and save time. Not a bad combination, if I say so myself. Let's crack on with the podcast. Now, the four key areas, the four key quadrants, areas of ratios that we're going to examine are profitability, liquidity, efficiency and investment ratios, or what we might see as risk and return ratios.

Let's tackle each of those in turn. Now, the concept of profitability is such that it's very important. Whatever your organisation is, whatever size you are, wherever you are in your business cycle, profitability, more than making revenue, has got to be a key number, a key part of your Northern Star. The ways in which we can look at profitability in a general framework. We can look at something called return on capital employed, sometimes abbreviated to ROCE. What a term, eh? We can look at the gross profit ratio and we can look at the operating profit ratio as well.

Those who have listened to the podcast over quite a number of episodes, you will know that financial people, if they can use one term to describe that, will use many different terms. So when we come to something like net profit ratio, you can hear it also described as the operating profit ratio. We've got look at the relationship of EBIT earnings before interest and tax. All those terms mean exactly the same thing. Now, let's look at each one in turn.

Let's look at return on capital employed. Now, from a financial perspective, capital is affecting the resources we have invested in our business by nature. The underlying fixed assets, the plant, the machinery, the capital equipment that provides our infrastructure and provides us the ability to produce the product and provide the service. What we want to do is to see how well those resources are being deployed to generate underlying profitability.

The calculation mechanism is we obtain a figure called operating profits or net profit, or EBIT that's the profit before tax and interest are considered and we relate that to the value of the resources at our disposal. Typically, capital employed is either going to be represented by the underlying fixed assets plus the working capital, or the equity of the firm plus its long term debt. When we calculate the ratio, it's expressed normally as a percentage. What we're looking at is an improvement on that ratio over a period of time.

If that ratio declined, there could be a number of reasons behind it. It could be a decline in relative profitability, it could be for positive reasons, perversely we've invested more in underlying infrastructure, but the actual level of profitability is such that it hasn't generated the same proportion. Our gross profit ratio, or gross profit margin as it's sometimes referred to, is measuring the level of gross profit we generate from our business in relation to the level of turnover. What we're looking for, ideally as a minimum, is a constant ratio year on year is typically expressed as a percentage. Any change in that measure over time, any change against the budget is normally due to a combination of a change in the underlying selling price of the item or item to be selling,

a change in the purchase price, the cost of manufacture, the cost of delivering that service directly. And obviously, what we're trying to do is to keep that ratio as a bare minimum at a constant number. That figure represents our resource poll for which we pay our overheads. Now the last number to look at under profitability is the operating profit of the net profit ratio. This takes the net profit of our organization, our firm,

looks at it in relation to the level of turnover that we're generating. And again, we're looking for a number that's going to be relatively constant. However, there can be changes. If the ratio improves over time, it typically could be because we're making more efficiency gains, we're making better gross margins, our level of expenses have not increased proportionally. Or it could be we're getting what's called economies of scale.

Economies of scale, if you imagine in your business, if you increase your level of turnover by 20%, certain costs, like rent, salaries to staff, will not go up by 20%. And if we manage to not increase those costs by the same magnitude, as turnover increases, what that means is we're spreading those underlying costs across a wider base and we have efficiency savings. If however, it goes the other way and we make a decline, it could be that we've got too much by way of overheads, by support costs in relation to the level of revenue.

Remember folks, ratios are a million indicator telling us these are areas that we need to focus on. Let’s now look at what's called liquidity. Now liquidity refers to the cash availability that runs around in the organisation. We know cash is a critical metric, it's a critical number. A lack of cash could spell the end of our business. The two headline ratios that are adopted are called the current ratio and the acid test or quick ratio. Let's take a step back and first we'll think how those numbers are calculated. Now the calculations of those two numbers, they're typically what are called balance sheet ratios. So that's where we look for and the current ratio looks at the total level of short-term or current assets,

typically inventory, receivables, money in the bank and it relates that to the level of short-term debt. Our current liabilities, typically current liabilities will include things like short-term loans under twelve months, overdrafts, payables i.e. amounts owed to suppliers, any accruals or short-term debts owing to suppliers. Now we look at that ratio and what that's telling us is that if we had to settle and pay off those liabilities pretty quickly, could we cover them? Now, the magnitude of the ratio again is particular to your business circumstance.

A very general, albeit sometimes questionable rule of thumb is that we typically look for two to one. But what really is that you're looking for is a number that's comfortable and we can manage. We don't want that number to decline. Now, within the current assets there is one item that is generally considered to be quite illiquid, ie. very difficult to turn into cash at short notice. And that item is inventory. Imagine you're a manufacturer, you could have what's called work in progress. So if you make chairs, you could have chairs in there that have only got two legs, materials that have already been worked on… If you're a service based business, you do have inventory as well.

You can have services you're providing. You've only done half the work of that and that's called work in progress. Now those items are very difficult to turn into cash at short notice. So what we say let's do a secondary test, eliminate the inventory and see how liquid we actually are. If we eliminate the inventory and relate it to the level of short-term debt or current liabilities, we'd expect the ratio to drop if we do in fact have inventory that we have in our business. If it drops dramatically, it would indicate high levels of inventory in our business.

A third category of ratios is what's called efficiency and there is a degree of overlap, by the way, folks, because some of these also affect the liquidity of our business. Now, the five numbers that I'm going to focus on in this particular presentation are as follows. We're going to look at the turnover to fixed assets. We're going to look at the expenses ratio. We're going to then look at inventory turnover or stock turnover, debtor collection period or receivables to give it more international term and also the payables payment period.

Those last three that I've mentioned, by the way. I'm also going to introduce something called an operating cycle. More of that to come in a few moments. Now, the turnover to fixed assets says and it's more relevant for businesses that have a high capital infrastructure. So retailers that have invested on physical premises, they've got a large amount of underlying assets, counters, equipment, machinery, manufacturers in the same boat. We're looking at the level of turnover we generate from those underlying assets. What we're looking for is to obviously generate more turnover in relation to the assets. But a note of caution.

In the world of accountants, fixed assets are what are called depreciated over time. So what that means is, as time goes on, those assets have a lower value in our company accounts. Therefore, even if we generate the same level of turnover year on year, we're going to get a higher ratio. So treat that number with a degree of caution. The expenses ratio typically looks at the support cost, normally the fixed cost of our business and looks at in relation to the level of turnover. Now, for this one, it picks up on this idea of economies of scale that I mentioned earlier. Imagine this particular scenario.

If you had a room full of ten people and you had £100 in your pocket and you shared that out equally, each person would receive £10. Now, if the number of people diminished and we only had half that number, each person would get £20. And lastly, if we increase the numbers of people in that room, let's say to 20, each person will get five. You might be thinking, what's that got to do with economies of scale? Well, that illustrates perfectly what happens if that £100 represents the level of costs, the level of support costs or overheads. And those variables that we introduced of five and 20 represented the sales activity.

The higher the sales activity, then the smaller are those costs per each pound. We get better economies of scale and we spread those costs across a wider base. Imagine the scenario that you've got staff that you're paying a salary for. If you do more business, their salaries don't go up accordingly. Therefore, you increase the level of profitability that you subsequently make. So the argument of having paid staff over subcontractors more of that in another podcast. The last three. If you imagine the HM of your business, you will have day-to-day bills to pay. You have running costs and we need to make sure we've got access to cash to keep those bills turning, to pay those short-term liabilities.

It doesn't make sense to sell our underlying fixed assets to service those short term debts. So we need to make sure our inventory, we turn it pretty quickly from the purchase of the raw material or the finished item to get it out the door. We need to make sure that our customers, if we have credit customers, that we get them to pay their bills as quickly as possible. And when it comes to suppliers, within reason not to take too much advantage over them, we want to pay their bills within a maximum time without upsetting the relationship.

Now, stock turnover is effectively going to be the average level of stock that we hold divided by cost of sales x 365. Receivables collection will be the level of trade debtors in relation to credit sales x 365. And lastly, the credit's payment period or payables payment period is the same thing. It's the idea of the trade payables in relation, strictly speaking, to credit purchases x 365. Now, if inventory turnover and receivables collection period goes up, that harms our cash flow. What that means is we need to have enough cash to finance the period of time we're waiting till we get those converting back into cash.

Creditors payment - the longer that time period, that means the more the cash stays in our bank account, the stronger we will be in liquidity. Now, if we imagine debtors and stop turnover as positive numbers, creditors pay it as negative. If we had those through, we get an operating cycle. What we're looking always to do is have the cycle as short as possible. If the cycle increases, it means we may be not as hot on our credit connection for customers as we would expect. Stock is lying around for much longer and it could be a combination of reasons

from slow-moving items, market tastes have changed… If we're manufacturing, there's some bottlenecks and slowdown in production process and therefore those are areas that we need to carefully look at. The last group of ratios we're going to look at is now what's called risk and return. And that's looking at it from an investor's perspective. The four most common numbers that I covered here are dividend yield, dividend cover, earnings per share, and price earnings ratio.

What are those four measures you might be asking yourself? Dividend yield looks at the level of dividend a shareholder will be receiving, the level of dividends paid out by a company in relation to the market value of that share. Think of it as a return just as much as you would look at the money that you save on deposit in a bank account. That gives you a percentage return from dividends. That's your income return. Dividend cover tells the company how adequately they can cover the dividend they are paying out to their shareholders.

That is going to be measured by the profits after tax and interest in relation to the level of dividend. The better the coverage, then the stronger the company is in terms of liquidity and making sure they can cover that dividend. Now, be cautious here. An investor may not be interested in the dividends they receive from an organisation or from a business. They may be more interested in the growth of the share price. So dividend yield is only part of the calculation. Apple, a company that pretty much everybody is aware of for many years in its early stages, did not pay dividends to its shareholders, whose shareholders were more interested in making share gains growth in share price. And the company was having that at its focus, preserving the cash and watching the stock price go up.

The last two measures here are earnings per share, or EPS. The measure is expressed as a number, typically, and it's going to be the level of profits after tax and interest in relation to the number of shares in circulation. Again, what we're looking for from a shareholder perspective, if that earnings figure goes up for each share they've got, that tells them their equity investment is generating a higher level of earnings. Again, we've got to take these figures with a pinch of salt. If you're a private listed company, then those ratios to some extent are quite meaningless.

They're only really relevant, I would suggest, when you've got a public listed company. The reason being private companies cannot easily sell their shares. Getting evaluation for those shares is notoriously difficult, but they are metrics nevertheless. And they're going to be more relevant when you look at PLCs, useful for when you're looking at company takeovers and the like. The last ratio I'm going to examine is the price earnings ratio. This is typically expressed as a number and it looks at the market price of a share in relation to the earnings per share. It's given as a multiple. Again, it has more relevance for a PLC, a public listed company.

For private companies, it has very little merit because there is no market price, there is no marketplace on which to compare it. It is still used, however, folks, again, a topic for another time when it comes to valuing businesses, but the number itself, typically when we're looking at PLC companies, the movement upwards of that number is a reflection that the stock market has more confidence in the company's future earnings prospects. If the PE ratio drops down, there is a perception by the marketplace that the company's fortunes going forward are questionable and certainly that expresses less confidence in the earnings ability of that firm.

OK, folks, let's wrap up what we've got. We looked at four areas general terms profitability, liquidity, efficiency and investment ratios of risk and return. We've looked at how the calculations are performed. We've shared some insight into what those numbers actually mean and we've talked about the way of expressing them. If you want to see a visual example, a work through example, then please check out the show notes and I'll give you a link to a YouTube video that I've done on that very same topic.

Folks, I hope you got some value out of this podcast. If you have, I'd love it if you could leave that wonderful endorsement. Leave me a comment. If there are topics that you want covered in future podcasts, the show is here for you, then please let me know. Check out the show notes for a link to our financial story planning platform, the way that you can forecast and plan and take control of the finances in your business. Until next week, folks, have a wonderful week and good luck with your ratio stories.

We hope you enjoyed this episode and appreciate you taking the time to listen to the show. We hope you got some value. If you did, then we'd love it if you shared the episode. We look forward to you joining us next week for another I Hate Numbers episode.