We’ve already started the discussion about financial ratios in the article What Are Financial Ratios? and will now go further.
Financial ratios are calculated to analyse management effectiveness in employing capital, solvency and profitability. The information contained in the Income Statement and Balance Sheet is essential to obtain financial ratios.
Of course, it is crucial to know the nitty-gritty of these financial statements. Then you don’t have to read them from A to Z, rather look through several figures and this is it. It is not only “sales” value. And it is not only for one period.
Then you may use cash flow management to improve those figures. Good cash flow management is the key to running a successful enterprise and will give you a competitive advantage.
Cash flow is identified as the issue most likely to influence business operations in the next quarter and it is affected by asset and liability changes in the business reflecting changes in working capital. Sounds confusing?
Imagine two retail companies with the same Net Profit. How to evaluate their financial performance regarding liquidity, efficiency, profitability and leverage (gearing)? Current Ratio and Acid Ratio will do the work. To refresh you on current ratio, it shows the extent to which a firm can meet its short-term obligations and it is calculated as = (Current Assets) / (Current Liabilities). And as to Acid Ratio, (Current Assets minus Inventory) / (Current Liabilities), and it Indicates the extent to which a firm can meet its short-term obligations without relying upon the sale of its inventory.
Some key data:
1. Other Current Assets (Stock) for Company A is 40,000 and for Company B is 75,000.
2. Total Current Assets are 130,000 for Company A and 110,000 for Company B.
3. Current liabilities are the same for both companies, 50,000.
4. Long term debt, nil in either case.
5. Interest Payable, 18,000 for Company A and 9,000 for Company B.
6. Net Profit is the same for both companies, 36,000.
Regarding their liquidity, both current ratios are greater than 1.0, so they both have acceptable ratios.
However the acid test ratio shows that Company B has liquidity problems, its quick ratio is well below 1.0, it may be unable to pay its short term obligations, even face bankruptcy.
It can be seen that although the two firms have the same profits, 36,000, Company B is insolvent as judging by the acid test. Any potential investor or lender may consider Company B at risk of insolvency and will severely limit the ability of the company to raise finance.
Now let’s look at the Interest Coverage Ratio (Net Income Before Interest and Taxes and Depreciation (EBITDA) / Interest Payable).
Company A has a low interest coverage ratio, 2.0, and it indicates a financial risk as if cash balances do not materialise as expected in the following year and it drops, to say half, the company will barely be able to pay financial charges.
On the contrary, Company B has a much higher interest coverage ratio, 4.0, indicating a low risk of insolvency and a greater ability to pay for external financing. Cash balances would have to fall substantially for the company to be unable to pay interest charges. Company B has a higher chance than Company A to raise further finance. Both companies have the same level of short term debt, 50,000.
The low interest coverage ratio reflects in the high cost of money for Company A, as creditors may be not very happy to provide credit to this company given the perceived inability of Company A to service the debt.
What about Working Capital? It is not just sales…. More details are needed here: current assets, composition of these assets in relation to cash or the quick convertibility to cash.
We will go further – how long does it take for your debtors to pay outstanding invoices? Who could imagine that there is a formula for this, and not a clock that you have to check all the time. This formula provides the Debtors Days Ratio and it is so simple: just divide two values taken from the income statement and the balance sheet, (Debtors x 365) / (Sales).
Will be continued…..
Stay tuned for our next post and meanwhile check on this How a Middle Manager Got Confidence, Translated it into Action and Got Promoted.