Are you a tradie looking to grow your trade business? Financial ratios are information-packed tools that can help you understand the overwhelming bits of data in your company’s financial statements.
Knowing how to select the right tidbits of information, when to combine with other KPIs, and how to interpret the resulting ratio is as much an art as it is a science. It is undoubtedly one of the most important tools of trade.
Learn these five key ratios to control your business:
1. Gross Profit Ratio
This is your most important number. It’s the amount left over after taking into account the direct costs of getting the job done. Direct costs include labour hours and materials, not general costs to the business, such as rent or admin salary.
Gross profit = sales - direct costs
For example, say you billed the customer $1,000 for the job, paid your staff $350 in labour and you bought materials for $350. Your cost for the job is $700. Gross profit is $300.
If you can increase your gross profit, then the money you are going to make from the business after you take home wages and your overheads is also going to increase. But this is easier said than done.
The gross profit ratio is the way to evaluate the performance of your business and you can calculate it using the formula below:
Gross profit ratio = Gross profit /Net sales
As per industry standards you should aim for 55% to 60%
Giving accurate quotes is a challenge for most tradies. They often end up either making loss because they underestimated the cost in the quote, or they charge more than quoted resulting in unhappy customers – either way it’s a loss for the business. The Gross Profit Ratio is an invaluable tool to use as a benchmark when working out accurate quotations.
2. Break-even point
Gross profit ratio can also be used to calculate your break-even point, i.e. the level of sales you need to achieve to make a profit:
Break-even = fixed expenses / gross profit ratio
For example, for a business with fixed expenses of $50,000 and a gross profit ratio of 40 per cent, break-even would be at sales achievement of $125,000 of sales.
3. Current Ratio
Current ratio, also called working capital ratio, shows if your business has the ability to pay off its short-term debts using its short-term assets, eg cash, inventory and accounts receivable. It’s to do with paying off your debts due within a year. These are called current liabilities on your balance sheet and include:
rent or mortgage payments
money owed to suppliers
short-term loans and credit cards
Current ratio = all current assets ÷ all current liabilities
Current ratio shows how your bills will be paid if your business doesn’t earn enough money. If you can’t pay what you owe, your lender or investor can sell your short-term assets to make up the shortfall.
A result higher than 1.0 shows your assets are worth more than enough to cover your debts. This makes you a safer bet for lenders and investors. Most importantly, it means your business model is on track.
4. Debtor days
This ratio is used widely within businesses to measure the effectiveness of a debt collection routine. It sets out the relationship between debtors and the sales that have been made on credit, and also shows how quickly customers are paying their invoices.
The calculation is:
Debtor days = debtors / turnover x 365. Current ratio = all current assets ÷ all current liabilities
If XYZ Electrical has an average accounts receivable balance of $300,000 and annual sales of $1,300,000 then its Debtor days is:
(300,000 ÷ 1,300,000) × 365 Days= 84.2 days
So, it takes XYZ Electrical an average of 84 days to get paid which is too high compared with industry standard assuming their payment terms are 30 days.
You can reduce this by prompt invoicing using accounting systems like Xero right after you’ve finished the job and providing your customers with more flexible payment options like credit cards. You can also have systems in place to send statements and automatic reminders from your accounting system, again Xero is great for this.
5. Cash flow
This is not a ratio but it is the most important factor in any business! Ensuring you get paid on time and proactively monitoring cashflow means you will be able to pay your bills and stay in business.
But because cash flow is ever changing, it can be difficult to keep track all the time. Your revenue will be affected from month to month, just as your outgoings will be affected by everything from staff wages to the power bill for your workshop, GST and tax payments.
If you lose track of your cash flow, you can lose track of your entire business.
You want to make sure your cash flow is always greater than zero. That lets you know you have more money on hand than what is going out the door. Cash flow is a moving beast so it pays to keep a regular eye on it.
Sounds so simple right? Yet, we know so many business owners struggle to keep a firm grip on their cash flow. We are here to help you monitor all aspects of your business to make sure your business stays healthy.