Financial Analysis

Business Ratios
In order to assess how your business is doing, you need to compare the ratios between the results of one year with that of another. The true meaning of the figures in your financial statements will only be highlighted when they are compared to other figures. The development of business and financial ratios has arisen because of the need for this comparison.

Ratios are generally very simple to calculate - some can be arrived at by expressing one figure as the percentage of another. Others are calculated by dividing the amount by another amount with the answer expressed as a percentage. Even though the ratios are simply arrived at, they can be very powerful because they provide you (as the business owner) with a quick grasp of the relationships that have been expressed.

When you have calculated and recorded a group of ratios relating to various years it will be easy, by doing comparisons, to evaluate the direction of the business. It will also enable you to pinpoint any improvements in your performance, or bring to the fore any areas that could be a potential problem. If you compare ratios to those of other businesses, you will be able to see areas that need improvement and the areas where you are well ahead of others.

There are a number of sources including; publications, trade journals, government bodies, etc that provide data for comparison purposes. Your accountant may have access to benchmarking information that will enable you to compare how your business compares to similar ones in your area. There are many types of financial ratios you can look at, but focus more on those that have meaning for your own type of business.

Ratios fall into four main categories:

  • Category 1: Liquidity ratios.
  • Category 2: Efficiency ratios.
  • Category 3: Profitability ratios.
  • Category 4: Solvency ratios.

Category 1: Liquidity Ratios
Liquidity ratios are the most commonly used business ratios. These ratios are sometimes called working capital ratios because they measure the liquidity in the business.

Banks and lending institutions often use them when they are evaluating loan applications and they may also be of interest to your creditors because it shows the ability of your business to meet your bills when they are due.

Liquidity ratios are comprised of 4 types:

  1. The current ratio.
  2. The quick asset ratio.
  3. Working capital.
  4. Debtor turnover ratio.

1. Current Ratio:
The current ratio is one of the best-known measures of financial strength. It answers the following question: “Does my business have enough current assets to meet my current debts, allowing for a margin of safety?” A generally accepted current ratio is 2:1. The best acceptable ratio obviously is when you have 1:1. This is usually playing it too close for comfort.

If you find that your current ratio is too low you can improve it by:

  • Paying some debts off.
  • Increasing your current assets from loans or other borrowings.
  • Converting non-current assets into current assets.
  • Putting profits back into the business.
  • Get further equity contributions to increase your current assets.

The current ratio is to do with measuring your short-term solvency and quickly identifies the ability of your business to generate cash when it needs to meet any short-term obligations. Any decrease in your ratio will mean that the ability is reduced.

The formula for calculating the current ratio is:

        Current ratio = total assets over total current liabilities.

2. Quick Asset Ratio:
The quick asset ratio is sometimes called the asset test ratio because it is one of the best measures of present liquidity. It is a much more accurate measure than the current ratio because it excludes stocks and concentrates on the assets that can be said to be really liquid. It answers the following question: “If all my sales income disappears could my business meet its current obligations with readily convertible quick funds on hand?”

A quick ratio of 1:1 is considered satisfactory unless the majority of your quick assets are in accounts receivable and the pattern of those receivable shows that collections lag behind the schedule for paying current liabilities.

The difference between the quick ratio and the current ratio is that quick ratio leaves out the stock figure from the current assets and compares the resulting figure to the current liabilities.

Some things you can do to improve your quick asset ratio is similar to how you improve your current ratio, except that you have to include stocks from current assets. Converting your stocks to cash or to accounts receivable will also improve this ratio.

This means that there is $1.22 in cash or near cash assets to meet every $1.00 of immediate commitment.

3. Working Capital:

Working capital is more to do with cash flow than ratio. The result of the working capital calculation must be a positive number. Lending institutions will look at your net working capital over time to determine the ability of your business to weather financial crises. In fact, these institutions will often tie minimum working capital requirements into the loans they make.

The formula for calculating working capital is:

            Working capital = total current assets – total current liabilities.

4. Debtors Turnover Ratio:
This ratio indicates how well the accounts receivables are being collected. If customers are not paying their accounts on time and the collections are not going as planned, then you should rethink your collection policy. If your customers are slow in paying you, your liquidity will be severely affected.