Know the SYMPTOMS – treat the CAUSE!
Business success is a result of a number of things, including good information and the sensible application of this information.
In The Springboard Academy’s previous posts, we looked at the different tools we use to gather and compile good information for a business.
Now, we need to look at what this information can tell us.
Note that the same information can produce different statistics, depending on the point of departure and the intended use.
Make sure that you take note of all the financial figures and other important information when making business decisions.
Example 1: This year’s financials show a profit of 10% of turnover. On its own, this looks great. The turnover, however, has been decreasing every year, and dropped by 50% last year.
This means that the business needs to be restructured to accommodate the lower sales or a fresh marketing campaign needs to be launched to recapture the lost market share.
Example 2: The business is growing its profits but the owner’s equity has moved into negative territory.
This indicates that the business is thriving, but the owner has his hands deep in the cookie jar, and is drawing most of the profits.
How to accurately diagnose the business’ financial health
Financial ratios indicate the relationships between different categories of Assets and Liabilities, and are determined from a business’ financial information. They are best used when compared to previous periods to determine a trend.
Put simply, a financial ratio is one key number from a company's financial results seen in relation to another key number.
There are a number of financial ratios that are used by big businesses in their financial management.
· Profitability Ratios
Gross Profit Rate = Gross Profit ÷ Net Sales
Return on Sales = Net Income ÷ Net Sales
Return on Assets = Net Income ÷ Average Total Assets
· Liquidity Ratios
Current Ratio = Current Assets ÷ Current Liabilities
Acid Test Ratio = Quick Assets ÷ Current Liabilities
Cash Ratio = (Cash + Marketable Securities) ÷ Current Liabilities
Net Working Capital = Current Assets - Current Liabilities
· Management Efficiency Ratios
· Leverage Ratios
But which ratios are important for a small business?
There are at least four key ratios to be followed through the actual performance of the business, and forecast through the budgets to ensure sound information and good decision making; solvency ratios and liquidity ratios. These must be used in conjunction with the profitability ratios of Gross and Net profit.
These must be analysed with other business activities to determine whether the business has a healthy heart rate, what the financial symptoms indicate, and what (correct) treatment is required.
1. Current Ratio = Current Assets ÷ Current Liabilities
This ratio evaluates the ability of a company to pay short-term obligations by using current assets, such as cash, current receivables, inventory, and prepayments.
Your business needs to record a ratio of more than 1.
2. Acid Test Ratio = Quick Assets ÷ Current Liabilities
Also known as the "quick ratio", it measures the ability of a company to pay short-term obligations by using the more liquid current assets or "quick assets", such as cash, and current receivables.
The difference between Ratios 1 and 2 is that stock is not included in the second calculation. This is because when realising quick cash from stock, you may have to reduce your price drastically, reducing the available cash value.
3. Net Working Capital = Current Assets - Current Liabilities
This ratio determines whether a company can meet its current obligations by using its current assets, and how much excess or deficiency there is.
It also indicates the amount of capital you have to continue trading. It is from this capital that you would pay your expenses and buy new stock. It is, therefore, important for this figure to remain sufficiently positive to grow the business.
4. The Solvency ratio = Total Liabilities ÷ Total Assets
The solvency ratio calculates whether there is enough value in the assets to settle all liabilities; the business’ ability to meet ALL of its commitments.
If you close the business today, and sell all your assets and collect all the cash, will there be enough to settle all the business’ debts too?
This ratio must be smaller than 1 to indicate solvency.
How to use the financial statements to diagnose conditions
There are a number of tools one can use to perform diagnostics on the business. Here is just one example:
This tool helps you visualise the trend in the all critical indicators. You will be able to see whether the trends indicate growth, including surpluses to be used for growing the business, or declining values, where a further capital injection may be required.
This tool is directly linked to your financial statements, and when comparing your business’ actual performance with your budget and the information gleaned from this template, you will be empowered to make informed decisions for your business’ future.
*Contact The Springboard Academy for access to integrated reports. Use the reference “Analysis” in the your message. The full template will be e-mailed to you.
**Remember, you are always allowed to ask for help as a business owner. Try to be informed enough to be able to use the information you are given.