Money matters

Cash and profit are not the same. Profitable businesses can run out of cash, and businesses can be temporarily 'cash rich' without being profitable.

Cash and profit are equally important. Managing your cash effectively is about making sure that you receive money owed to you before you spend it. Profitability comes from running your business effectively, making sure that your pricing is right and controlling your costs.

Managing your finances

You need good-quality information that gives you confidence that you are:

Good information is a way of checking that your business is going in the right direction. 'Financial ratios' will help you to assess the performance of your business. A number of useful ratios can be seen below:

Useful calculations - financial ratios

This appendix contains some of the key indicators used by businesses to keep track of their performance.

Liquidity ratios

A business should normally have enough current assets (such as stock, work in progress, debtors and cash) to cover current liabilities (such as an overdraft and creditors). Liquidity ratios show the ability to meet your liabilities with the assets you have. The 'current ratio' shows the relationship of current assets to current liabilities:

Current Ratio = Current assets
  Current liabilities

This should usually be between 1.5 and 2. If less than 1 (so current liabilities are more than current assets), it means that the amount of working capital you have may be becoming an area for concern - you may be relying on bank borrowing or delaying paying creditors to finance your trading. You may possibly be relying on another source of finance for your daily operating expenses. If it is not between 1 and 2, it doesn't necessarily mean that your business is run badly, but it could be a danger sign. You might ask, for example, how pressing your creditors or the bank are for repayment, and if you are generating enough money to meet these liabilities?

If it is over 2, you may not be making the best use of your current assets. You need to make sure that you are:

A stricter test of liquidity is where current assets which could be hard to sell, such as stock and work in progress, are not included. The remaining current assets of debtors and cash (or 'quick assets') are compared with current liabilities to give a 'quick ratio':

Quick Ratio = Quick assets
  Current liabilities

This should normally be around 0.7 to 1, although this can depend on the industry. If the current ratio is rising and the quick ratio is static, you may have too many debtors.

It can be helpful to work out the number of days that the business can exist if no more cash flows into it. This is called a 'defensive interval' - as a guide, it should be 30 to 90 days, though it also depends on what industry your business is in:

Defensive Interval = Quick assets
  Daily operating expenses.

Finally, the Net Working Asset ratio shows the working capital that a business needs to support sales:

Net Working Asset Ratio = Stock + debtors - creditors x 100

It shows how much working capital you need for every �0 of your sales. Usually this would need to come from cash or bank borrowing, so this ratio can be useful for estimating how much extra cash you would need to finance an increase in sales.

2 Solvency ratios

If your total liabilities are more than total assets, then your business is technically insolvent. That means that if your business closed, it would not be possible to repay all the people you owe money to. Allowing a business to trade while insolvent is now an offence, so you need to watch the figures closely. The ratio of the money that you have borrowed (for example, loans, overdrafts and hire purchase) to the total capital of the business (owners' or shareholders' capital and reserves) will show the 'gearing' of the business. Generally, the more money you borrow, the higher the gearing:

Gearing = Total borrowing
  Total capital

Gearing is important in assessing how much the business can afford to borrow. A well-established rule of thumb is that a bank would not normally like to have more money in a business than the owners themselves have invested, at least until it can demonstrate its success. This is because a bank's money is not its own to lend and there must be a good certainty of getting it back. However, exceptions are often made for new businesses or in other special circumstances. Also if your Cashflow and profits are stable you can afford higher gearing. Profits kept in the business add to your stake in the business and therefore increase your ability to borrow safely. Losses worsen gearing and make the business vulnerable and because of this, another measure to use with gearing is your profit compared with the interest on your loans, or 'interest cover':

Interest Cover = Profit before interest and tax

This shows how easily you will be able to pay interest on any borrowing. If it is over 4 it is very good; if it is under 2.5 it might show that you could have problems if interest rates go up.

3 Efficiency ratios

These show how much working capital is being used, how quickly you can collect unpaid debts and pay your creditors, and how effective you are in controlling stock and making your cash work for you. The first ratio tells you the number of times unpaid debt is 'turned over':

Debtor Turnover Ratio= Sales

Ideally, use the average debtors for a particular period. You can estimate this by dividing sales by debtors at the end of a period. If you divide this ratio into the days of the year, you can get an annualised collection period for the number of days to collect debts:

Debtor Collection Period = 365 x Debtors

You need to keep tight control of your debtors. Keep the collection period as short as you can. Many businesses offer 30 days, but often it can be worse than that. Again, it depends on the business you're in. Monitoring how long it takes you to pay your suppliers is as important as knowing how long your customers take to pay you. If suppliers have to wait too long, they may withdraw your credit. For this purpose, use the 'creditor turnover ratio':

Creditor Turnover Ratio = Sales

As with the Debtor Turnover Ratio, you can divide this ratio into the days of the year to get an 'average payment period':

Creditor Payment Period = 365 x Creditors

Normally, the cost of sales is used to calculate the average payment period. It can be interesting to compare your business with another one, and you can do this by estimating your competitors' cost of sales. Ideally, your average creditor payment period should be more than your average debtor collection period. Otherwise, you're paying the money that you owe before you get the money for what you've sold, and you will probably find that your business will be short of cash. Stock will increase when you are expanding and decrease when you are shrinking. For some businesses, such as wholesalers and some retailers, a high 'stock turnover ratio' is essential to make any profit. Again, the level of stock turnover will depend on the industry. A low stock turnover ratio might show that stock is moving too slowly, which means that measures may need to be taken to dispose of it:

Stock Turnover Ratio = Cost of sales
  Average stock at cost

How quickly the stock 'turns' or is sold is another helpful figure:

Average holding period = 365 x Average stock at cost
  Cost of sales

4 Profit ratios

There are a number of simple ratios that show how profitable you are. The 'gross profit margin' is one figure that you should watch closely. It is probably the most important of all ratios as a pointer if your business is going 'off track':

Gross Profit Margin = Gross Profit x 100

The 'net profit margin' gives you the picture after taking off your overheads and interest, but before tax:

Net Profit Margin = Profit before tax x 100

An increasing figure shows a good control of overheads.

Some useful tips

Use ratios to examine trends and identify problems. They will never solve problems for you, but they might lead you to the cause.


One big mistake that some business-owners make is to think that all customers are prepared to pay the same and that there is a 'rate for the job'. All jobs are different and should be priced according to the complexity of the task. It is important to work out an average price for your product or service that you need to maintain each year.

Working out this average price is straightforward. . .

Add up the answers to 1, 2 and 3.
Then divide this total by the answer to 4.

For example:

Overheads of �,000
Drawings of �,000
Tax of �000
Need to make �,000
Expected earning days 182
�,000/260 = �2 a day or � an hour.

If the price for each hour or day, or the selling price of the product, seems higher than the market will pay, then your business has no future and you will have to find ways of doing some things differently. For example, you could reduce costs by working from home, or you could specialise in a different segment of the market which may be prepared to pay a higher price.

If you have not worked out your price like this, you could soon end up in trouble. It is also vital not to be too optimistic about your earning potential of the number of 'saleable' hours you can work. A large amount of the time in the business will be spent marketing, selling, solving problems and keeping up with financial information.


The basis of all business decisions is good information. The better your information the better your ability to make the right decisions. The secret of good financial management is to use information about your previous performance to steer your business into the future. Problems should be identified early enough for you to be able to put them right.

Breakeven point

Breakeven is the level of sales you need to cover all of your costs (both fixed and variable). It is a very useful way to monitor how profitable your business is. You can work out your breakeven point by dividing your fixed costs (costs that are fixed regardless of your level of sales) by your 'gross profit margin'.

Using the annual breakeven figure, you can produce a very informative, simple graph to show how profitable (or not) your business is over a particular period.

The graph shows an example breakeven chart. A straight line is drawn showing the breakeven point at the end of the 12-month period. This can be compared with actual or/and budgeted sales to assess the profitability of the company. In the example the predicted sales of �9,000 are much higher than the breakeven figure of �,000. If these sales levels were achieved the business would be highly profitable. However if actual sales only reached �,000 (shown by the red line), the business would be showing a loss.

In this situation, the business can only recover and survive by increasing sales or improving the gross profit margin. The higher you can operate above breakeven point, the greater your margin of safety.

Gross profit margin

Keeping and trying to increase your gross profit (profit before taking off fixed costs) margin is of vital importance. Compare it with the calculations you made at the start of the year. When the gross margin falls below what you expect, the effect on your business can be devastating. The typical reaction to difficult trading conditions or poor performance is to reduce prices to try to increase sales volume. You then have to put in more work for less return, as shown in the charts below. Chart A shows how much extra business you would need to generate to make the same gross profit if you reduced your prices. For example, a company with a gross profit margin of 25% would have to increase their sales by 67% to compensate for a 10% price reduction.

On the other hand, Chart B shows what volume of business you can afford to lose if you put your prices up. For example a company can afford to lose 29% of their existing volume of business, if they increase their prices by 10%.

Existing % Gross Margin
  5 10 15 20 25 40 35 40 50
% Price
% volumeincrease required for samegross profit
2 67 25 15 11 9 7 6 5 4
3 150 43 25 18 14 11 9 8 6
4 400 67 36 25 19 15 13 11 9
5   100 50 33 25 20 17 14 11
7.5   300 100 60 43 33 27 23 18
10     200 100 67 50 40 33 25
15       300 150 100 75 60 43

Chart A

The negative effect of reducing your price - sales have to increase hugely for you to remain profitable.

Existing % Gross Margin
  5 10 15 20 25 40 35 40 50
% Price
% Volumedecrease to gain the same profit.
2 29 17 12 9 7 6 5 5 4
3 37 23 17 13 11 9 8 7 6
4 44 29 21 17 14 12 10 9 7
5   50 33 25 20 17 14 11 9
7.5   60 43 33 27 23 18 16 13
10 67 50 40 33 29 25 22 20 17
15 75 60 50 43 37 33 30 27 23

Chart B

The positive effect of increasing your price - sales can decrease sharply and you remain profitable.

These charts demonstrate why businesses get sucked into a spiral of decline and failure during difficult times. They cut prices believing that they have to maintain turnover. As we can see, this action has a huge effect on gross profit - sales have to go up to compensate. Often, the most difficult thing to do is to increase sales. And when the necessary increase in sales does not happen, many businesses react by reducing prices yet again -another loop in the spiral to failure! A good business will try to reach a better gross margin. Profit is the key to business, not sales.

The wise business person realises that 'turnover is vanity, profit is sanity, but Cashflow is reality'.


Any decision you take in business affects your tax situation. Tax is traditionally viewed in a negative way by just about everyone. But in business, you pay tax if you are profitable, so look at it positively.

If you plan, you can reduce the tax you have to pay. It is important to see your professional adviser before the end of the financial year. Help and guidance is available from your professional adviser, the Tax Office and numerous publications.

Debtors and creditors

Some people find these words confusing.
Debtors are people who owe you money and creditors are those you owe money to. If you pay your bills faster than your customers pay you, your business will need more cash.

However long you give customers to pay you must chase your debtors for money when it becomes overdue. You depend on payment from customers to run your business. If a customer is consistently late in paying you, ask yourself if you really want a customer who has the potential to destroy your business. Likewise, if you treat your suppliers badly, do not be surprised if they decide not to do business with you.

A 'debtor matrix', is a helpful way to monitor the speed at which your debtors pay their bills. This is completed by adding up how much money your debtors owe you at the end of the month and how long each bill has been unpaid.

The chart below shows an example debtor matrix for a business repairing and servicing 'fleet' vehicles. The company's contract requires trade debtors to settle their accounts within 60 days. The matrix shows that there are two debtors who have amounts owing past 60 days. The company needs to seriously consider whether to keep trading with these companies.

Debtor matrix
Amount Owing (�)
Debtor Total Under 30 days 30-60 days 60-90 days More than 90 days
1A 1000 500 500    
2B 1000 0 1000    
3C 5500 2000 500 3000  
4D 1500 1500 0    
5E 4000 0 4000    
6F 4000 4000 0    
7G 0 0 0 0  
8H 1000 0 1000    
9I 8000 3000 2000 2000 1000
10J 2000 1000 1000    
Total 28,000 12,000 10,000 5000 1000

Remember that every 30 days, debts which remain unpaid move into the next column.