Finance for Non Accountants - Part 2

Introduction

This is the second leaflet in a two part series of Finance for Non-Accountants and concentrates on analysing a set of financial statements so they become more meaningful for the reader. Analysing financial statements through comparative ratio analysis will help managers identify and quantify the company's strengths and weaknesses and evaluate its true financial position.

Certain financial ratios can be used to evaluate a company’s performance and obtain further information on the financial health of the company. All the information required to calculate the financial ratios is already contained in the financial statements. Here are the major quantitative ratios that are useful for measuring the financial position of your business.

1. Profitability Ratios

Profitability Ratios can be used to measure the trend of the business earnings and the ability of the company to earn profit over time. Comparison of profit margins to other companies and to previous periods should also indicate where the business is doing well. Profit margins should also indicate where a business has room to manoeuvre on pricing.

The important profitability ratios are as follows:

1. Gross Profit Margin % =	Sales – Cost of Sales (Gross Profit)*100
	Sales

Normally gross profit will rise in proportion with sales so the gross profit margin can highlight any efficiency in the use of resources.

2. Net Profit Margin % =	Net Profit *100
	Sales

The Net Profit Margin Ratio is widely used as a measure of performance across similar companies in similar industries. A business working on a low margin may not be reason for concern if the particular industry has a high turnover e.g. supermarket. It is important to compare this to the industry average or other businesses in similar industries.

3. Return on Capital Employed % =	Net Profit * 100
	Capital Employed

Return on Capital Employed shows the annual percentage return that an investor receives on their capital. Capital employed is essentially net assets.

This ratio gives an indication of what return you are making on the money financing the business.

2. Liquidity Ratios

These ratios indicate the ease that a company has to turn assets into cash. A business must be able to perform positively in relation to profitability but must also be able to pay creditors, expenses and loans as they fall due. The Current and Acid Test Ratios are the best known measures of this financial strength. These are calculated as follows:

1. Current Ratio=	Current Assets
	Current Liabilities

The Current Ratio compares the relationship between current assets and current liabilities and is intended to indicate whether the business has sufficient current assets to meet the current liabilities. The widely accepted standard holds that current ratio should be at 2:1,that is the current assets should meet current liabilities by at least twice.

2. Acid Test Ratio=	Current Assets - Stock
	Current Liabilities

The Acid Test Ratio measures current assets that are quickly converted to cash compared to current liabilities. Stock is excluded as it recognises that it is not easily converted into cash. An acceptable figure is considered at 1:1, that is current assets, excluding stock should meet current liabilities.

3. Asset Utilisation Ratios

The Asset Utilisation Ratio measures how effectively the business uses its assets including debtors, stock and other assets and the speed at which the assets are converted to sales and cash.  The two most important ratios to assess the effectiveness of asset utilisation are:

1. Average Debtors Days=	Debtors *365 Days
	Annual Credit Sales
Example (Company Z):	2006:32 days	2005:42 days	2004:50 days

This Average Debtor Days Ratio measures the number of days that it takes for the debts to be collected by the business. A short collection period implies prompt payment of debtors and an excessively long collection period implies inefficient collection procedures.

2. Stock Turnover=	Average Stock *365 days
	Sales or COS

This ratio measures the number of times stock turns over in a business. A high stock turnover would indicate that the business is in fast moving goods. The example above shows an increase in days, which indicates a slow down of stock turnover.

Conclusion

As we have outlined any manager can use their financial statements to get further information on the company’s financial position and ratio analysis can give you an indication of the performance of your business. Ratio Analysis enables the business owner/manager to spot trends in a business and to compare its performance and condition with the average performance of similar businesses in the same industry. However a ratio on its own has little meaning and these ratios must be compared to previous years, the industry average and competitors to give them a true meaning.

Analysing your financial statements through ratio analysis may provide important early warning indications that allow you to solve your business.