A.V. Tony Narinesingh, CMC, CPC, APC, CC
The Finance function in your business is far too important to be left to financial or accounting specialists whether you are a practicing financial consultant or a business owner. You must ensure that you at least develop and understand the fundamentals of financing and accounting as this will help you to take the "gut feeling" out of your decisions and gauge more accurately the performance of your business. Remember, you may have the best business plan presentation, range of products or marketing program, but investors ultimately invest in the capability of management to meet or exceed the stated objectives - that is YOU!
Ratios are guidelines and must be considered together with other factors, such as, volatile economic conditions, collateral, asset turnover, industry performance, confidence and track record of the owners, etc. A financial ratio is a useful tool only when compared with other ratios. By itself, it is ineffective and useless and will not help you to determine the health or performance of a business. Ratios used in financial statements reflect the mathematical relationship between two amounts and are expressed in percentages, fractions or decimals. While ratios will not provide solutions for existing problems, they can pin-point operational difficulties for management to take corrective action. For your information, the following explains some of the most widely used financial ratios used in analyzing financial statements:
Used to assess the profitability of the business as well as a yardstick to compare the industry average. If the ratio is below the industry average, the causes should be investigated. Gross Margin = Divide Gross Margin by Net Sales.
Net Worth :
This is often referred to as, owner's equity or capital or net assets or book value in the balance sheet. It represents the excess of total assets over total liabilities. It is the amount of money that is tied up in the business at a given time, i.e., the invested capital plus or minus the retained earnings/deficit. Net Worth = Invested Capital + or - Retained Earnings/ Deficit
Return on Investment:
Often referred to as Return on Equity or Return on Net Worth, ROI is the return on the original investment of Investors/Shareholders plus subsequent earnings retained in the business. ROI = Net Income after Taxes divided by Net Worth.
Return On Assets:
This ratio shows the profits generated from the use of tangible (production) assets. Goodwill, incorporation costs, deferred charges, etc., are not included. ROA= Net Income after Taxes divided by Total Tangible Assets.
Net Working Capital:
While technically not a ratio, this is a practical and precise cash management tool as it indicates whether the company's current assets exceed its current liabilities. It also shows the ability to meet short term obligations and monitor any potential liquidity crisis that may arise. Net Working Capital = Current Assets minus Current Liabilities.
This ratio is related to Net Working Capital. It calculates the ratio between current assets and current liabilities. A lower ratio indicates that the company is less able to meet its obligations with its cash flow in a timely manner. Current Ratio = Divide Current Assets by Current Liabilities.
Often referred to as the "Acid Test", it is the ratio used to determine operating difficulties. A negative ratio suggests that a company obligations to creditors cannot be met within a 30 day period out of accounts receivable unless other sources of funds are available. Quick Ratio = Divide Current Assets minus Inventories minus prepayments by Current Liabilities.
This ratio addresses a company's ability to repay long term debt. It is invaluable in planning, managing and negotiating long term borrowings with a bank or lender. Managing and reducing debt obligations effectively are directly affected by interest rates, profit margins and term of the loan. Debt Coverage = Net Income after Taxes plus Amortization plus Interest divided by Principal plus Interest Repayments.
Price to Earnings:
In evaluating a company's financial position the P/E ratio - Market Price per Share divided by Earnings per Share - is important in determining the quality of the earnings, i.e., realistic earnings or monies earned after consideration of various factors which will affect the earnings quality of a company. This ratio is used when making equity financing decisions as a low P/E ratio means low earnings quality resulting in higher interest rates and cost of borrowing, lower bond ratings, and/or lower market bond pricing as well as fewer chances of attracting funding. Accounting policies may affect earnings quality. If a company's policies are very liberal in relation to realistic industry standards, earnings quality would most likely be lower. Therefore, you should always compare your accounting policies with those considered to be Industry standards. Some managements may be inclined to indulge in some form of income smoothing, that is, reporting artificial earnings. This should be avoided as they do not reflect actual economic results. You should be aware that a weak relationship between sales and net income may be an indication of income smoothing.
In assessing a project, a bank or lender as well as the company's management would and should try to determine the probability of failure by examining the trend in key ratios, such as,
In addition, in appraising the financial picture, the following areas should be carefully analyzed for indicators of possible failure:
Financial Forecasting and regular investigations of your financial performance can often detect problems that are often the cause of business failure. The importance of historical financial information is often underrated. Management need to recognize the importance of regularly evaluating and learning from past performance while using this data to plan for the future. For instance, the Cash Flow Statement may show problems of cash mismanagement, the Income Statement may reveal dwindling sales or high expenses in a particular area, and the Balance Sheet which shows Assets, Liabilities and Equity, may show problems with Accounts Receivable and Inventory, or confirm the insolvency of the business. If you can detect these problems early, you can invariably take corrective action.