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Five financial ratios

To help you navigate your business finance, here is an explanation of five key terms you’ll most likely come across: Gross profit margin, net profit margin, current ratio, inventory turnover and return on owner’s equity.

  • The average gross profit on each dollar of sales before operating expenses: 

An extract from the balance sheet.
  • It will depend on the industry you’re in, so it’s important to measure yourself against industry benchmarks
  • It is an excellent way of assessing the profitability of each product  

  • The percentage profit your business makes for every dollar of revenue: 

The capitalised earnings valuation.
  • It tells you whether you’re making a profit after covering all your costs
  • It will be partly determined by your industry ­– some retailers run high-volume, low-margin businesses, others sell a few expensive items with plenty of margin built in

  • Helps measure the solvency of your business by comparing current assets (like unpaid invoices) to current liabilities (unpaid bills):

Current ratio = current assets / current liabilities
  • Ideally, your current ratio should be two or more, which means your assets are at least double your liabilities
  • If sales are growing and you have a short operating cycle, a lower number may be fine
  • If you have a long operating cycle, you may want a higher current ratio to make sure liabilities don’t get out of control 

  • Particularly useful if you have trading stock
  • Shows how often your business’ inventory is sold and replaced in a particular period: 

Inventory turnover = cost of goods sold / inventory
  • For example, if you’ve spent $200,000 on stock over the year and you keep an average of $20,000 worth of stock on hand, your inventory turnover is 10 times a year
  • As a general rule, it is better to have a higher than lower inventory turnover
  • A low turnover indicates you have a lot of money tied up in stock for long periods, which is not good for cash flow
  • Too high a figure could indicate that you don’t have enough stock on hand

  • Compares your net business income to the equity you’ve invested in the business
  • It reveals how much you’re making from your investment: 

Return on owners equity = net income / owners equity
  • For example, if you’ve invested $200,000 and the business is generating a net income of $100,000 a year, your return on owner’s equity is 50 per cent
  • It tends to increase over time as the business grows, especially if your personal investment remains the same
  • It’s a useful way to compare what you’ve earned from your business to what you may have earned from another investment 

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Important information

As this advice has been prepared without considering your objectives, financial situation or needs, you should, before acting on the advice, consider its appropriateness to your circumstances. All products mentioned on this web page are issued by the Commonwealth Bank of Australia; view our Financial Services Guide (PDF 59kb)

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