Chapter 2 of the Business finance basics section in the 'Achieving financial success' series

Chapter 2 of the Business finance basics section in the 'Achieving financial success' series
Chapter 2: Assessing your business's financial health

By David Searle*

A helpful tool that can be used to predict the success, potential failure and progress of your business is financial ratio analysis.

Financial ratio analysis will provide the all-important warning signs that could allow you to solve your business problems before they destroy your business.

By spending time doing financial ratio analysis, you will be able to spot trends in your business and compare its financial performance and condition with the average performance of similar businesses in the same industry.

Although there are many financial ratios you can use to assess the health of the business, in this chapter we will focus on the main ones you can use easily. The ratios are grouped together under the key areas you should focus on.

HINT
These ratios measure if your business has adequate long-term cash resources to cover all debt obligations.

Liquidity ratios

These ratios will assess your business’s ability to pay its bills as they fall due. They indicate the ease of turning assets into cash. They include the current ratio, quick ratio and working capital (which is discussed in detail in chapter 5).

In general, it is better to have higher ratios in this category - that is, more current assets than current liabilities - as an indication of sound business activities and the ability to withstand tight cash flow periods.

HINT
Use these ratios to assess if your business has adequate cash to pay debts as they fall.

One of the most common measures of financial strength, this ratio measures whether the business has enough current assets to meet its due debts with a margin of safety.

A generally acceptable current ratio is 2 to 1; however, this will depend on the nature of the industry and the form of its current assets and liabilities. For example, the business may have current assets made up predominantly of cash and would therefore survive with a relatively lower ratio.

Sometimes called the “acid test ratio”, this is one of the best measures of liquidity. By excluding inventories, which could take some time to turn into cash unless the price is “knocked down”, it concentrates on real, liquid assets. It helps answer the question: If the business does not receive income for a period, can it meet its current obligations with the readily convertible “quick” funds on hand?

Financial ratio analysis will provide the all-important warning signs that could allow you to solve your business problems before they destroy your business.

Solvency ratios

These ratios indicate the extent to which the business is able to meet all its debt obligations from sources other than cash flow.

In essence, it answers the question: If the business suffers from reduced cash flow, will it be able to continue to meet the debt and interest expense obligations from other sources?

Commonly used solvency ratios are:

The leverage (or gearing) ratio indicates the extent to which the business is reliant on debt financing versus equity to fund the assets of the business.

Generally speaking, the higher the ratio, the more difficult it will be to obtain further borrowings.

This ratio measures the percentage of assets being financed by liabilities. Generally speaking, this ratio should be less than 1, indicating adequacy of total assets to finance all debt.

TIP
These ratios indicate the extent to which the business is able to meet its debt obligations from all sources, not just cash flow (as is the case with liquidity ratios).

Profitability ratios

These ratios will measure your business performance and ultimately indicate the level of success of your operations. More discussion on these measures is found in Chapter 4.

HINT
Use gross and net margin calculations to measure and monitor the profitability of your business operations.

This ratio measures the percentage of sales dollars remaining (after obtaining or manufacturing the goods sold) to pay the overhead expenses of the business.

This ratio measures the percentage of sales dollars left after all expenses (including stock), except income taxes. It provides a good opportunity to compare the business’s return on income with the performance of similar businesses.

TIP
Comparing your net and gross margin calculations with those of other businesses within the same industry will provide you with useful comparative information and may highlight possible scope for improvement in your margins.

Management ratios

Management ratios monitor how effectively you are managing your working capital - that is, how quickly you are replacing your stock, how often you are collecting debts outstanding from customers and how often you are paying your suppliers.

These calculations provide an average that can be used to improve business performance and measure your business against industry averages. (Refer to Chapter 5 for more detail.)

HINT
Use the number of days for stock, debtors and creditors to calculate the cash conversion rate for your trading activities.

This ratio reveals how well your stock is being managed. It is important because it will indicate how quickly stock is being replaced.

Usually, the more times inventory can be turned in a given operating cycle, the greater the profit.

This ratio indicates how well the cash from customers is being collected - referred to as accounts receivable.

If accounts receivables are excessively slow in being converted to cash, the liquidity of your business will be severely affected. (Accounts receivable is the total outstanding amount owed to you by your customers.)

This ratio indicates how well accounts payable are being managed.

If payables are being paid on average before agreed payment terms and/or before debts are being collected, cash flow will be impacted. If payments to suppliers are excessively slow, there is a possibility that the supplier relationships will be damaged.

TIP
Comparing your management ratio calculations to those of other businesses within the same industry will provide you with useful comparative information that may highlight possible scope for improvement in your trading activities.

Balance sheet ratios

These ratios indicate how efficiently your business is using assets and equity to make a profit.

HINT
Use the return on assets and investment ratios to assess the efficiency of the use of your business resources.

This ratio measures how efficiently profits are being generated from the assets employed in the business. It will have meaning only when compared with the ratios of others in similar organisations.

A low ratio in comparison with industry averages indicates an inefficient use of business assets.

The return on investment (ROI) is perhaps the most important ratio of all, as it tells you whether or not all the effort put into the business is, in addition to achieving the strategic objective, generating an appropriate return on the equity generated.

TIP
These ratios will provide an indication of how effective your investment in the business is.

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The full Guide is available in the .pdf attachment, or here »

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David Searle is an Assurance Services Partner with Staples Rodway and is the immediate past president of CPA Australia New Zealand Division . You can contact them directly here »

You can read the Introduction to this series here »  The related Glossary is an important resource. And readers are encouraged to read this page first »

Chapter 1 is about Understanding Financial Statements and you can read it here »

Chapter 3 is about Budgeting and will follow next week.

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