Using key financial ratios to assess the performance of your business

Jakarasi

To get a balanced assessment of the performance of your business you need to use both financial and non-financial information. However in this discussion I will concentrate on how you can use financial ratios, derived from financial information, to determine the financial health of your business or any other business, in respect of its liquidity, solvency, profitability, efficiency and investment potential.

You need to take time to assess the financial status of a business, or the business you have dealings with or one you want to buy. A business might look healthy from outside but after a financial analysis you might notice that there are serious underlying problems that you can only pick through an analysis of the financials. Certain key financial ratios give valuable insight into how an organisation is being run. Financial ratios help you to make good informed decisions. All these financial ratios are derived from the organisation’s income statement, balance sheet and cash flow.

For financial ratios to be meaningful you need to compare them with the budgets or with prior performance, or another organisation in the same industry sector or they have to be compared with industry averages. On their own ratios will not show anything meaningful. A point to note when comparing with other organisations is that sometimes the figures might not be very comparable because the other organisation might be using different accounting policies or the same organisation might have changed policies from one year to the other.

When you are comparing organisations in different countries you should also know the impact of seasonality, or different use of financial terms and the impact of different laws on comparability. If you don’t take cognisance of these issues then your ratios will give misleading information and eventually wrong decisions. You also need to be aware of any operational practices in different countries that will affect the financial information. For instance if you are analysing businesses that sell vehicles in other countries vehicles might only be registered twice a year whereas in your country it could be throughout the year. Such different operational practices will make figures meaningless unless you make adjustments to accommodate this.

Financial ratios are categorised by what they measure, namely, liquidity, solvency, profitability, efficiency and investment potential.

Liquidity represents a company’s ability to meet its short-term obligations.  An organisation is considered healthy if its current assets are enough to pay its current liabilities. There are two ratios that are used to calculate the liquidity of a business, the current ratio and the acid ratio. The current ratio is calculated by dividing current assets with current liabilities. If the ratio is two or more then the organisation is said to be healthy since the current assets can sufficiently meet the payments of all current liabilities if they are called.

Current assets are made up of stocks, debtors and cash whereas current liabilities are made up of trade creditors, other creditors and bank overdraft. In most cases this ratio is complemented by the acid ratio or acid test. The acid ratio excludes stocks in the current assets and so it uses current assets less stock divided by current liabilities. If the ratio is one or more than one it indicates that the business is healthy. This ratio is usually calculated together with the current ratio because sometimes the current ratio might look very good but if the current assets include a lot of stocks the business might not be that liquid to be able to meet the payments of current liabilities immediately. This is because stocks take time to convert into cash.

The other category of financial ratios is the solvency ratios. Solvency is the ability of a company to meet its long-term financial obligations including the associated interest payments and its ability to continue operations into the foreseeable future. For a business to be considered solvent, the value of its assets must be greater than the sum of its debt obligations.

The solvency of a business is calculated using the debt to equity ratio which shows how the business is financed, whether it’s being financed too much by debt or it’s by equity. If a business is being financed by a lot of debt then that business is referred to as highly geared. A highly geared company is good for tax purposes in a period when the business is performing well because interest payments are tax deductible.

However if the business is not performing well, that is, if it’s not profitable and it’s cash flows are stressed then it can spell doom to the business because any failure to meet debt obligations can lead to bankruptcy. Another solvency ratio is interest coverage ratio which is operating profit divided by the interest charge. This ratio shows the business’ ability to pay the interest on its debt. A higher solvency ratio indicates that the business is solvent since it can adequately cover its interest. An ailing business will not be able to cover its interest from its profit.

We will continue our discussions on financial ratios in the next article.

About the author

Stewart Jakarasi is a business & financial strategist and a lecturer in business strategy and performance management. He provides advisory and guidance on leadership, strategy and execution, preparation of business plans and on how to build and sustain high-performing organisations. For assistance in implementing some of the concepts discussed in these articles please contact him on the following contacts: sjakarasi@gmail.com or +266 58881062 or on WhatsApp +266 62110062