Glossary of Terms
The purpose of this ratio is to measure the company’s ability to meet its short-term financial obligations as they fall due.
What is an acceptable level will vary from one type of business to another but traditionally a ratio of 2 is regarded as appropriate for most businesses to maintain creditworthiness, however more recently a figure of 1.5 regarded as the norm.
The higher the ratio, the more likely the company will be able to meet its liabilities. A too high a figure should be regarded with suspicion as it may be due to high cash levels, which could be put to better use by investing in longer-term investments.
Current Ratio = Total Current Assets/Current liabilities (Creditors: amounts falling due within 1 year)
Current Liabilities to Net Assets
This ratio indicates to suppliers how credit-worthy you are as an organisation. It helps them decide whether they should offer you favorable credit terms or whether, for example, they should request payment upfront.
It measures the funds creditors are risking with your organisation temporarily, against the funds permanently invested in the business.
Normally a business starts to have trouble when this relationship exceeds 80%.
Current liabilities to net assets = current liabilities (Creditors: amounts falling due within 1 year)/Net Total Assets
The calculation looks at the amount due to creditors within a year as a percentage of the overall assets of an organisation.
Number of months of operational costs provision
This ratio shows the number of months the company could operate before running out of cash.
The general rule of thumb is to have at least 3 months of operating costs to provide a level of comfort to the board that in the event of a drop in funding or sales, there would be sufficient time for replacement funding or sales to be secured. This however will differ by sector.
Calculation = Calculation: Net Current Assets / (Operational costs/12)
Debt to Equity Ratio
Investors and creditors are interested in not only the short-term liquidity of a company but also its solvency or ability to remain in business over the long run. The capital structure of a company is the focal point in making this determination. Most companies need a minimum investment by the owners to start a company. Many businesses benefit by incurring debt. Finding the right mix and managing that mix of debt to equity is as important to the long-term health of the company as working capital is to the short-term health of the company. The Debt to Equity ratio is a common measure for long-term viability. A debt to equity ratio of 50% or below is considered a safe level of debt. If a company has a debt to equity ratio above 50% it could be considered highly leveraged and therefore in a higher risk category.
Calculation: Total liabilities/Total Shareholders Funds
Collection Period Ratio (Days)
The debtor collection period measures the average number of days which elapse between making a credit sale and receiving payment for it.
The debtor collection period provides an insight into the company’s credit control system, typically an organisation is looking for this to be 30 – 45 days. However, this will differ by industry sector, for example you would expect in a restaurant where most food is paid for at the time of purchase the collection period to be very low, whereas for a company manufacturing furniture the typical terms may be 45-60 days from the point of the invoice being issued.
An increase in the debt collection period over time might indicate the system is not operating as efficiently as it was in previous years - this would be a trigger to investigate the debt collection process and terms.
Calculation = (Debtors/Credit sales turnover) x 365 days
Turnover to Assets Ratio (%)
This ratio looks at how effectively you are utilising your organisation assets. It compares the total income being generated to the total asset base that is used to generate the income.
If the percentage is abnormally low, it indicates that an organization's assets are not being fully utilized.
Turnover to Assets Ratio = Total Turnover/Total Assets
For property-based or non-service type businesses we are looking for a ratio of 70% or more.
Turnover to Net Working Capital Ratio
This ratio should be viewed as answering the question: "Are we staying in business by delivering profitable services or are we relying on the credit granted by our suppliers to keep us afloat" i.e. if we are not making enough margin are we delaying payment to our suppliers to float the operation.
Measures the number of times working capital turns over annually in relation to net turnover. Should be viewed in conjunction with the assets to turnover ratio.
A high turnover rate can indicate overtrading (excessive sales volume in relation to the investment in the business). A high turnover may indicate that the business relies extensively upon credit granted by suppliers or the bank as a substitute for an adequate margin of operating funds.
Calculation: Turnover / (Current Assets - Current Liabilities).
Creditors to Turnover Ratio (%)
This ratio measures how the company pays its suppliers in relation to its turnover.
A percentage of 30% or lower generally indicates a healthy ratio. A high percentage (over 30%) indicates the company may be using suppliers to help finance operations.
Calculation: Creditors (amounts falling due within one year) / Net Turnover
Profit Margin (%)
This ratio measures the profitability of an organisation. It measures the profits or surplus after taxes on the year's turnover (£ profits/surplus earned per £ of turnover).
The higher this ratio, the better prepared the business is to handle downtrends brought on by adverse conditions. Although profit margins will differ by industry, most businesses will be looking for a profit margin of 10% or more.
Calculation: Net Profit / Net Turnover
Return on Assets Ratio (%)
This ratio shows how effective a company is at generating profit from its assets (such as buildings, plant and equipment).
A high percentage shows the company is operating well and using its assets well. We are looking for a ratio above 60%.
However, some caution is required as the figure for total assets of the company depends on the value of the assets on the balance sheet. Many organisations have undervalued assets on the balance sheet - such as buildings where the building has been depreciated however the market value may have risen.
Return on Assets = Gross Profit/Total Assets
Return on Equity
This ratio is measuring the typical return an investor could expect when investing in your organisation. You want to be looking at anything above bank savings interest rates as if people are looking to invest in an organisation they will want to ensure they are getting a better return that simply puting their money in the bank (a safe bet). However, for most 3rd sector organisations the social benefit is highly valued and therefore this may outway the financial return. However if you are competing with similar organisations who are managing to obtain a higher financial return which then allows them to invest more in their social mission, a social investor may chose to invest in your competitor rather than you.
Return on Equity = Gross Profit/Total Shareholders Funds