How it’s Calculated
Growth Capacity calculation:
$ of Net Profit – ($ of Current assets – $ of Current liabilities)
= ______________________________________ x 100
How it’s Used
This ratio shows whether the business is capable of easily funding a higher turnover base. A positive result for this calculation indicates that the business should be able to fund its growth from additional profits; a negative result suggests that the business might experience liquidity problems if it grows.
So your result is negative, what can you do?
First, increase the ‘profit’ side of the equation:
- Promote more of your high-margin products or services – this can flow through into a higher net profit margin;
- Make your ‘production’ or ‘service’ processes as efficient as possible – this saves both overheads and labour;
- Focus on cost control through the entire business – what you use; how much you pay for it; how much you waste, and so on.
- See if you can reduce the owners’ drawings (whether they take the form of salary, or dividends or drawings, the end-result is still the same) – this keeps more of the profit in the business.
Second, reduce the amount of money tied up in the business:
- Reduce stock levels, if this can be done without losing sales;
- If your business has ‘work-in-progress’, re-design your work methods or policies so that jobs are completed more quickly, or negotiate staged billing of your customers at key stages during the ‘production’ process;
- Clearly outline your trading terms to customers, and make sure that someone in your business follows-up the slow-payers regularly – bill promptly, and ask for the money!
- Have enough cash to cover the foreseeable needs, then use the balance to reduce interest-bearing debt;
- Stretch creditors as far as possible within their trading terms.
The one constraint is to keep a sensible ‘current ratio’ while all this is happening: long-standing rules of thumb talk about current assets being around 1.5 to 2 times current liabilities, in order to be commercially sound. Retailers can get away with slightly lower levels, due to the high cash component in their sales.
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