How to Determine Your Business Success With a Financial Ratio

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By: Site Engineer, Staff

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Understanding New Venture Financing

One of the biggest parts of the move into a new business by the entrepreneur is the careful and thorough calculation of whether or not the proposed venture will be financially worth your while. Usually, this question will ring in your mind “will be business be financially feasible?

The most essential point is that business must make a financial return (i.e. net profit) and generate cash flow sufficient to provide:

  • A fair and reasonable reward (wage) for your work based personal expenses and the time, effort, experiences, skill, etc., you will put into the business.
  • An adequate return on your equity or financial investment in the business.

There is a 6-step process that will enable you to understand how to estimate capital requirements startup costs and sources and application of funds.

Now let us assume that you want to go into the dry-cleaning business.

Step 1 What is my personal net worth?

Step 2  What is my personal (family cash) need?

Step 3  What funds do I need and where will they come from?

Funds are needed for:

  • Obtaining assets (either by purchase or leasing)
  • Paying startup (e.g legal costs)
  • Working capital (i.e leasing)
  • Repaying loans (for first 6 months at least)
  • Personal cash needs (Step 2)

Funds may be available from:

  • My own net worth (Step 1)
  • Investment(s) by other(s) (i.e partner(s), shareholder(s)
  • Loans of various kinds (using personal net worth and/or business assets as security)
  • Suppliers (trade) credit (= stock and materials) (short terms)

Most starters, badly underestimate the firm’s need for enough working capital to cover wages, purchases and all other operating costs for at least 6 months. This can be a particular problem if most sales are credit sales.

Step 4  What net profit must the business earn?

Step 5 What will it cost ruin my business?

Having determined what the business should return to you as a desire Net Profit you now need to budget overheads, (operating expenses), the business must cover before any Net Profit will be generated on a monthly basis.

Knowing the size of your operation, using standard rates, getting quotes, talking to other business owners, or your accountant, a carefully estimated overhead budget can be prepared for the next 12 months, at least. This is the beginning of your profit and loss budget.

Step 6  What sales must the business generate to cover this overhead plus my desired return (in the form of Net Profit)?

Break-even Sales (Total Overhead + Net Profit) x Industry Gross Profit Margin

Cash Flow Statement

A lot of businessmen do not understand the difference between profit and cash. It is often assumed that the increase in profit from growth in sales volume will automatically show itself in the bank account as cash.

Consequently, the business, aiming at growth, is likely to over trade (i.e., expand so rapidly that it outgrows its initial structure and capital resources) in an attempt to develop business. In the circumstance where the necessary cash was available, this would be desired and profitable.

Management realizes too late that growth requires additional possessions in the form of inventory and work-in-progress, and a greater level of money outstanding from customers (accounts receivable) which often take demands on cash at a greater rate during stages of growth that can be met from profit. Such a situation has caused the failure of many businesses.

Cash Flow Statement and Cash Budget

This statement is of much use to management in decision-making and provides advance information of its probable short-and longer-term, financial requirements.

A cash-flow forecast is an estimate of cash receipts and payments for a future period before any necessary adjustments have been made, whereas a cash budget is the estimate of cash receipts and payments for a future period after due consideration has been given to expected conditions and the overall budget plan. The “adjustments” which may take place before the cash budget is compiled are action to obtain any necessary cash, or to invest any amount, which is in excess of current requirements.

Strictly speaking, a “Cash Forecast” is a forecast of what the cash position will probably be, whereas a “Cash Budget” shows the intended cash position. Cash forecast should, therefore, precede a cash budget and should call for a careful look at what is likely to happen in terms of trends.

N.B (The concern is with cash expected to be paid and received within the period creditors’ and debtors’ balances are not included; neither is depreciation or any provision on reserve not paid out in cash).

A study of the cash forecast may reveal that there is a shortage of cash. If the volumes of production and sales anticipated in the forecast are not to be adjusted, then more cash has to be found.

Decisions to be taken by Management

  1. Should cash required to be obtained from permanent capital or short-term borrowing?
  2. Can improvement, in efficiency not result in cost reductions?
  3. Can changes in prices and discounts not help to speed up the inflow of cash?
  4. Can salary and wage freezes and careful control over spending not have beneficial results (i.e., assuming these measures are possible without introducing more problems?)
  5. Will extension of the period of credit allowed by creditors and reduction of stocks carried to improve the cash situation?
  6. Assets may be bought on hire purchase; alternatively, they may be hired and a hire rental paid.
  7. Property (e.g., buildings) may be sold and a lease obtained on them or the business may lease the property instead of buying, thus conserving cash resources.

If there is a large cash surplus, steps may be to invest it, either by expansion or purchase of external investments.

The form of the Cash Budget will be the same as for the Cash Forecast. Any difference between the two is not in the layout and preparation, but in what the figures represent. The Cash Budget figures then become part of the Budgetary Control System after any necessary adjustments to the cash forecast have been made, but not before.

Estimating Capital Equipment Needs (Business Planning Exercises)

Estimating start-up cost accurately is the first step in calculating how much money you will need to capitalize your venture. Start-up costs are those expenses you must incur before you open your doors. These costs include decorating and remodeling, equipment, professional fees, deposits, and salaries. You cannot project your break-even point (e.g., the point where expenses equal revenues) without figuring in these costs. Estimate the amounts as best you can now and re-estimate when you have collected more accurate date.

Instruction: The following exercises will help you estimate the start-up costs for your business. In the first Business Planning Exercise below, list all capital equipment you need to start your business (note the difference between major and minor equipment). In this exercise, list all the start-up expenses you are aware of at this time.

Reading and Understanding Financial Statements

Reading of financial statements involves analysis and interpretation of accounts. The accounts to be analyzed are the trading and profit and loss accounts and the balance sheet.

(A) Purpose of Analysis

The primary object of analysis of accounts is the provision of information. Analysis, which does not serve this purpose, is useless. The type of information provided depends on the nature and circumstances of the business and the terms of reference.

(B) Interested Holders

(a) Debenture Holders: As a secured creditor, the debenture holder is mainly concerned with the realizable value of the assets, which form the security. He will, therefore, pay attention to the followings:

  • The basis of valuation of assets – whether depreciation has been provided out of profit and if so, is it adequate?
  • Whether any provision has been made for repayment of debentures or replacement of fixed assets.
  • Adequacy of working capital (for without cash resources the debenture interest cannot be paid).
  • Profits earned – repayment of debenture interest depends on the earning of profits.

(b) Trade Creditors: When and if he has access to the accounts, he will note the followings:

  • The existence of secured debts
  • The net balance available for unsecured creditors
  • The existence of uncalled capital and undistributed profits.
  • The adequacy of working capital

(c) Bankers: In addition to all the above, a banker will ask two questions:

  • What security has the potential borrower to offers?
  • Will the loan (or overdraft) if granted, enable the borrower to increase his profits sufficiently to pay the interest and in time repay the loan?

(d) Shareholders: The average shareholder is interested in the future dividend he will receive. Future profits are of secondary importance so long as they are adequate to provide divided. Past dividends provide the basis on which future dividends may be estimated.

(e) Accountants: Apart, from other considerations, the accountant will watch out for:

  • The way in which the legal requirement is satisfied.
  • The form in which the accounts are presented e.g., whether informative, in the modern style, or not.

(C) Financial Ratios

A very useful way of analyzing accounts is by means of financial ratios. An accounting ratio is one figure in a set of accounts expressed in terms of another in the same set of accounts. Ratios are frequently expressed as percentages.

The main uses of ratio analysis are:

  • To help diagnose a situation
  • To monitor performance
  • To help forward planning

With information from ratio analysis, management can analyze business situations and monitor the performance of their own and competitors’ firms. All ratios must be compared with a standard to determine whether they are at a satisfactory level or not. The comparison can be made with:

  • The company’s own past
  • The company’s target ratios (obtained from the forecast profit and loss account and forecast balance sheet)

(D) Some Useful Performance Ratios

Using the profit and loss account and the balance sheet.

1. Profitability

  • Gross Profit Ratio
  • Net Profit Ratio
  • Return on Capital

There are many definitions of Capital Employed but three of the most common are:

  • Gross Capital, which consists of all assets employed. As a basis for calculating the Return on Capital Employed, it gives the most conservative result.
  • Net Capital, which is gross capital less current liabilities (this is the one used in this context).
  • Proprietors’ Net Capital, which refers to the capital invested by the shareholders.

2. Liquidity

(a) Current (or Working Capital Ratio)

Current Assets/Current Liabilities

(b) Quick Ratio (or Liquidity Ratio or Acid Test Ratio)

Liquid Assets/Current Liabilities

Liquid assets here refer to cash, good debtors and marketable securities (i.e., those assets that can be very easily converted to cash).

3. Stock Turnover Ratio

Materials Used per annum at cost/Average Stock held

(Average Stock Equals average of opening stock and closing stock)

4. Debtors’ Turnover Ratio (or Average Collection Period)

Trade Debtors at year-end/Total Credit Sale for the year

This ratio indicates the efficiency of debt collection. This period can then be compared with past performance, expected performance and other performances. Remedial action should be taken if necessary.

5. Creditors Turnover Ratio (or Average Payment Period)

            Sundry Creditors at year-end              x          365


            Total Credit Purchase for year

6. Financial Structure

(a)        All Debt/Equity Ratio:

            Current Liabilities + Long-Term Liabilities


                                    Owner’s Equity

            (b)        Long Term Debt/Equity Ratio:

                        Long-Term Liabilities


                             Owner’s Equity

(E) Limitations of Ratio Analysis

(a)        Businesses often use ratios to indicate a trend and as a basis for policy decisions. The disadvantage is that no business is statist, and a ratio is calculated from a set of figures at some time in the past.

(b)        Unless the ratios are extracted at frequent intervals, the trends indicated could be most misleading. If ratios are extracted at frequent intervals without delay, they can be very useful management tools.

(c)        However, ratios give significance to the figures shown in the account; they are useful, in comparing two or more companies in the same line of business and for detecting and trends over a period of years.

It should be noted that there are many types of accounting ratios in use; each business normally devises ratios suited to its own requirements. The commonest ones are the few already discussed above.

 

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