Entrepreneurs are born from a wide spectrum of backgrounds, from engineers to designers to even homemakers. Naturally, many of them are not technically equipped to perform financial analysis on their businesses.
Many sceptics claim that financial ratios do not represent the truth about their businesses, especially at an early stage, since ratios use historical figures that do not account for recent changes to the business. But the reality is, investors and other external parties do look at the numbers. While ratios miss out on future opportunities a business presents, they do give objective information about past performance for stakeholders to make better decisions.
Different Types and Applications
1. Common-size Ratios
Common-size ratios are a concept that makes it easy to compare businesses with one another. It simply means dividing an item by the total amount. Items in the income statement is compared against total sales whereas items in the balance sheet are compared against total assets, total liabilities plus total equity depending on the item.
Gross profit and net profit margins always arouse interest for investors, to look at the feasibility of the business model in its relevant sector. Common-sizing individual expenses can also highlight abnormally large expenses to initiate necessary investigations, such as over-inflated advertising expenses.
2. Liquidity Ratios
Almost every business utilises credit for payment terms with customers and suppliers. Insufficient cash flow is a huge obstacle that results in the failure of many businesses. Liquidity ratios are extremely important as they give a glimpse of a company’s ability to pay for its expenses on time. The two popular ratios used are the current ratio and the quick ratio.
Current Ratio = Total Current Assets / Total Current Liabilities
Current assets and liabilities have short lifespans, allowing stakeholders to understand the risk of the business being unable to fulfil its short-term obligations that may require drastic actions. However, an overly high current ratio means that cash is not being utilised efficiently to maximise returns for investors.
Quick Ratio = (Current Assets − Inventory) / Current Liabilities
The quick ratio, also known as the acid test ratio, excludes inventory from current assets. The liquidity of inventory is often questioned as it requires stable and strong market demand for it to be liquidated into cash. For example, when new technology comes along, demand for existing technology plummets which can make it difficult to liquidate inventory to cash. Hence, this ratio shows the ability of the business to withstand a sudden shock that would impair cash flow and continued sales.
These ratios are not just important to investors, but also for managers to watch for alarm bells to prevent cash flow problems from snowballing into irreversible situations.
3. Efficiency Ratios
Efficiency ratios diagnose the operational health of the business, revealing which part of the business operations require more attention (e.g. collection, payment, inventory etc.). While there are many different ratios that can analyse a business’s operations, we will look at 3 popular ratios – inventory turnover, average collection period and return on assets (ROA).
Inventory Turnover = Cost of Goods Sold / Inventory
Inventory turnover calculates the amount of inventory produced that is converted into sales over a period of time. A decreasing inventory turnover shows a slowdown in sales relative to inventory build-up. This can also help businesses make better purchasing decisions to reduce inventory-related costs such as warehousing.
Average Collection Period = 365 x Net Receivables / Net Sales
This ratio tells you the average number of days that a customer takes to pay for the products or services. It would be important to ensure that credit terms with suppliers are minimally similar to prevent cash flow problems. Identifying a low collection period is also an opportunity to offer more competitive terms to customers if the business can have the affordability.
Return on Assets = Net Income Before Taxes / Total Assets x 100%
ROA is extremely important as it shows how well a business makes use of its assets to generate a return. A good ROA varies greatly across different industries. The technology industry has the highest ROA of 10.66% while the financial industry has the lowest ROA at 1.27%.
4. Solvency Ratios
Leverage has long been considered a double-edged sword. It has been used by many investors from big banks and investment firms for the famous leveraged buyouts (LBOs), to retail investors who trade or invest on margin, and even the everyday man on the street who takes up a mortgage to buy a house or uses a credit card.
Debt allows borrowers to capitalise on opportunities today even when resources are lacking. However, it comes with the cost of an obligation to provide a return on that borrowed capital which presents a risk when the opportunities are not sufficiently productive. Solvency ratios provide a base to assess the risk of a company for investors and lenders.
Debt to Equity = Total Liabilities / Total Equity
Liabilities often carry an obligation to repay according to set terms whereas equity does not usually come with it. A higher debt to equity ratio symbolises higher risk for investors and lenders to undertake and this usually translates into a higher required rate of return.
However, this ratio must be analysed across industries and with other indicators such as the ROA. A company with a high and stable ROA would benefit from higher leverage to buy more assets that have a higher return than the cost of borrowing. This would also benefit investors as financing through equity would result in dilution and is typically more costly than debt due to the higher risk.
Essential for Business
Regardless of how great a business idea is, financial analysis is the common language of business, connecting all sorts of stakeholders – investors, suppliers, managers. Despite its limitation to account for ongoing market situations, financial ratios do reflect a certain truth about a business and are sufficiently objective to improve decision-making processes for all stakeholders. This provides an avenue for managers to use this common language to negotiate with external parties.
For example, 2 prominent reasons why companies fail are the lack of a market need and insufficient cash. Financially equipped managers would be able to identify these problems fast through ratios like inventory turnover and quick ratio and take actions to improve through organisational changes.
As the market constantly changes, financial analysis is imperative to highlight pressure points that require immediate attention quickly. It is an important tool that every entrepreneur must have to thrive in an increasingly competitive market.
About BlackStorm Consulting
BlackStorm Consulting is a boutique growth consultancy firm that specialises in corporate strategy, profit management and investment management. We mainly serve clients in four sectors: FinTech, Gaming, Technology, Media and Telecommunications (TMT), and manufacturing.
Our clients and connections are internationally present and range from small and medium sized businesses, MNCs, to government agencies.