Monthly financial ratios: 4 to watch
After preparing the income statement, the balance sheet and the cash flow statement, you have three reports full of numbers, but the owner wants a shorter answer: are we better or worse off this month? Financial ratio analysis gives that answer in 4 ratios you calculate monthly: the quick ratio, collection days, debt to equity, and profit quality. More important than the value of each ratio is its direction compared with last month.
Example: the caterer's September ratios
We stay with the same caterer and take the figures from its approved September statements:
| Line | Statement | September (SAR) |
|---|---|---|
| Revenue | Income | 208,000 |
| Net profit | Income | 35,600 |
| Bank and cash | Balance sheet | 87,000 |
| Customer receivables | Balance sheet | 46,000 |
| Current liabilities | Balance sheet | 92,400 |
| Total liabilities | Balance sheet | 152,400 |
| Equity | Balance sheet | 211,600 |
| Cash from operations | Cash flow | 59,800 |
Ratio 1: the quick ratio
In the balance sheet lesson we calculated a current ratio of 1.89. But it counts inventory and prepaid rent, and neither pays a supplier tomorrow. The quick ratio takes only what turns into cash fast: (bank and cash 87,000 + receivables 46,000) ÷ current liabilities 92,400 = 1.44. Every riyal due within a year is matched by 1.44 riyals in hand or close to collection. If it drops below 1, cash and receivables do not cover what you owe, and you need faster collection or agreed extra time from suppliers.
Ratio 2: collection days
How many days of sales are waiting with customers? Receivables ÷ the month's revenue × days in the month. September: 46,000 ÷ 208,000 × 30 = 6.6 days. August: 38,000 ÷ 196,000 × 31 = 6.0 days. The number is still small, but it went up, and that is where the collections follow-up lesson comes in, before it grows.
Ratio 3: debt to equity
How much of your business is funded by others compared with what you put in and left as profit? Total liabilities 152,400 ÷ equity 211,600 = 0.72. For every riyal of the owner's, there are 72 halalas owed to suppliers, customers who paid deposits, and the bank. If it rises month after month, you are funding growth with debt more than with profit, so check it before any new loan or large drawing.
Ratio 4: profit quality
Did profit turn into cash? Cash from operations ÷ net profit = 59,800 ÷ 35,600 = 1.68. That looks excellent, but the cash flow lesson showed that SAR 15,000 of it was rent paid before September and 8,000 was deposits for banquets not yet served. Without them: 36,800 ÷ 35,600 = 1.03, so profit turned into cash almost riyal for riyal. A ratio below 1 for several months means profit is sitting in receivables or inventory.
Running it from WhatsApp
Owner (3 October): In short, were we better or worse off in September than in August?
System: September ratios: quick ratio 1.44, collection days 6.6 against 6.0 in August, debt to equity 0.72, and profit quality 1.03 after excluding income received in advance. Profit is higher, and collection is slightly slower.
Owner: Who is late?
System: 3 customers owe SAR 22,000 from September. Shall I send you their names with the invoice dates?
Owner: Send them
Note that the owner did not read three statements, just four numbers and one question that led to a decision. More on Arabic accounting from your phone.
Checklist before you read the ratios
- Did you take the figures from the approved statements after closing the month?
- Did you leave inventory and prepayments out of the quick ratio?
- Did you use the actual number of days in the month for collection days?
- Did you remove one-off items from profit quality?
- Did you put each ratio next to last month and ask about any change?