How to use financial ratios to improve your business

One way of putting financial data into a comparative context is known as financial ratio analysis. From a financial accounting standpoint, ratio analysis enables external constituencies to evaluate the performance of a firm concerning other firms in that particular industry. This is sometimes referred to as comparative ratio analysis. From a managerial accounting standpoint, ratio analysis can assist a management team to identify areas that might be of concern. The management team can track the performance of these ratios across time to determine whether the indicators are improving or declining. This is referred to as trend ratio analysis. There are scores of financial ratios that can be calculated to evaluate a firm’s performance. Financial ratios provide you with the tools you need to interpret and understand such accounts. They are essential if you want to look in detail at a company's performance.

As the financial reports of a business contain a wealth of financial information, it is important to consider why we are analyzing and interpreting the financial reports. The users of financial reports are wide-ranging and include a variety of stakeholders: investors, creditors, customers, and employees. What do such stakeholders want to know?

· Is the business profitable?

· Can the business pay its bills?

· How is the business financed?

· How does this year compare to last year?

· How does our performance compare with our competitors?

· How does the business compare to the industry norms?

Financial ratios: What you need to know for financial analysis

There are 3 main categories of ratios: Profitability Ratios, short-term liquidity ratios, and long-term liquidity ratios.

1. Profitability Ratios

The absolute level of profit may indicate the size of the business, but on its own, it says very little about company performance. To evaluate the level of profit, profit must be compared and related to other aspects of the business. Profit must be compared with the amount of capital invested in the business, and to sales revenue.

Profitability ratios will inevitably reflect the business environment of the time. So, the business, political and economic climate must also be considered when looking at the trend of profitability for one company over time. Comparisons with other businesses in the same industry segment will indicate management's relative ability to perform in the same business and economic environment.

Return on Total Assets

Return on total assets is a measure of profit from the total assets invested in the business and ignores how such assets have been financed. The total assets of the business provide one way of measuring the size of the business. This ratio measures the ability of general management to utilize the total assets of the business to generate profits.

Return on Capital Employed

ROCE, sometimes called Return on Net Assets, is probably the most popular ratio for measuring the general management performance of the capital invested in the business. ROCE defines capital invested in the business as total assets less current liabilities, unlike ROTA, which measures the profitability of total assets.

Net Profit Margin

The net profit margin, sometimes known as the trading profit margin measures trading profit relative to sales revenue. Thus a trading profit margin of 10% means that every 1.00 of sales revenue generates .10 (10p) in profit before interest and taxes. Some industries tend to have relatively low margins, which are compensated for by high volumes. Conversely, high-margin industries may be low volume. Higher-than-average net profit margins for the industry may be an indicator of good management.

Net Asset Turnover

The net asset turnover ratio measures the ability of management to utilize the net assets of the business to generate sales revenue. A well-managed business will be making the assets work hard for the business by minimizing the idle time for machines and equipment. Too high a ratio may suggest over-trading, that is too much sales revenue with too little investment. Too low a ratio may suggest under-trading and the inefficient management of resources.

2. Short-term liquidity ratios

Short-term liquidity is the ability of the company to meet its short-term financial commitments. Short-term liquidity ratios measure the relationship between current liabilities and current assets. Short-term financial commitments are current liabilities, which are typically traded creditors, bank overdrafts PAYE, VAT, and any other amounts that must be paid within the next twelve months. Current assets are stocks and work-in-progress, debtors, and cash that would normally be re-circulated to pay current liabilities.

The key short-term liquidity ratios are:

Current Ratio

The current ratio is a general indicator of the business's ability to meet its short-term financial commitments. This ratio assumes that all current assets if required, can be converted to cash immediately to meet all current liabilities immediately. Many texts recommend that the current ratio should be at least 2:1, that is current assets should be at least twice the value of current liabilities. Presumably, this is to allow a safety margin, as current assets do not usually achieve their full value if they have to be converted to cash in a hurry.

Nowadays, it is very difficult to prescribe a desirable current ratio. Technological advances in stock and inventory management have reduced the value of stocks on many balance sheets. Aggressive financial management strategies by large companies have resulted in higher levels of trade creditors, and a tightening grip on trade debtors. It is therefore important to look at the trend for an individual business and to compare businesses within the same industry segment.

Acid Test

The acid test or quick ratio is the current ratio modified to provide a more prudent measure of short-term liquidity. The acid test ratio deducts stock and work-in-progress from current assets. This approach is more cautious as it recognizes that stock is not always readily converted into cash at full value.

3. Long-term liquidity ratios

Long-term liquidity or gearing is concerned with the financial structure of the company. Long-term liquidity ratios measure the extent to which the capital employed in the business has been financed either by shareholders through share capital and retained earnings, or borrowing and long-term finance.

The key long-term liquidity ratios are:

Gearing Ratio

The gearing ratio measures the percentage of capital employed that is financed by debt and long-term finance. The higher the gearing, the higher the dependence on borrowings and long-term financing. The lower the gearing ratio, the higher the dependence on equity financing. Traditionally, the higher the level of gearing, the higher the level of financial risk due to the increased volatility of profits.

Financial managers face a dilemma. Most businesses require long-term debt to finance growth, as equity financing is rarely sufficient. On the other hand, the introduction of debt and gearing increases financial risk. But the company dependent on equity financing alone is unable to sustain growth. How much debt can a company take on before the benefits of growth are overtaken by the disadvantages of financial risk?

Interest Cover

While the gearing ratio measures the relative level of debt and long-term finance, the interest cover ratio measures the cost of long-term debt relative to earnings. In this way, the interest cover ratio attempts to measure whether or not the company can afford the level of gearing it has committed to.

The overall analysis of financial ratios

When analyzing the financial results of a company, or comparing several companies it is tempting to become so involved in calculating a wide variety of financial ratios that the original purpose is forgotten. Why are we looking at the financial reports? What do we want to know?

Let's go back to the key questions at the beginning of this blog post. These key questions indicate that the financial health of a company is dependent on a combination of profitability, short-term liquidity, and long-term liquidity. Historically, greater emphasis was placed on profitability. Since the difficulties of the recession in the late 1980s liquidity, both short-term and long-term, has increased in importance.

Companies, which are profitable, but have poor short-term or long-term liquidity measures, do not survive the troughs of the trade cycle. As trading becomes difficult in a recession such companies experience financial difficulties and fail, or maybe take over. In contrast, companies, which are not profitable but are cash rich, do not survive in the long term either. Such companies are taken over for their cash flow or by others who believe that they can improve the profitability of the business. Thus, those companies that do succeed and survive over the long term have a well-rounded financial profile and perform well in all aspects of financial analysis.

It is important when reviewing each aspect of financial performance to highlight any significant changes in performance, either compared to last year or compared to a competitor. Highlighting significant changes enables you to focus on key events or major factors that may have important implications for the company.

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