Over the years, a great many useful analysis techniques have been developed for financial management.
Ratio analyses and break-even analyses are among the most popular. These concepts are not easy to describe and we only provide an introduction to them.
For a better understanding of them you should look for other sources, or discuss them more thoroughly with your accountant. The information we do provide however, should give you a general understanding of these techniques.
The most important concept is break even analysis. The break even analysis determines the point at which the number of services provided, or merchandise sold, by your business begins making a profit.
Determining business stability
Ratio analysis was developed to determine the stability of various financial aspects of a business.
It enables the small business owner to determine what the financial weaknesses and strengths of the business are, so that appropriate action can be taken.
Ratio analysis also offers a view of the competitive performance of your company in relation to similar businesses in your industry.
Don’t make the assumption that ratio analysis will tell you everything you need to know about the financial performance of your business.
It provides a great deal of information, but it does have some limitations. Although ratio analysis compares current and past performances of the company, it doesn’t offer any indication of future performance.
Ratios are developed for specific periods. If you operate a seasonal business, ratios may not provide an accurate measure of financial performance.
Not all businesses are the same. Ratios are usually comparisons with industry averages, however your business will not, and should not be, exactly the same.
Keep in mind when making comparisons with a single entity, that financial statements are often prepared by different methods, resulting in financial ratios that may not present an accurate account of the average business in your industry.
Measure of liquidity
The first financial ratio to discuss is a measure of liquidity.
This ratio analyses the available liquid assets your business has at any given time to meet current liabilities.
The measure of liquidity tells you how much cash-on-hand you have, the assets that can readily be turned into cash and how quickly you can do so.
A good rule of thumb to determine your financial health is the more liquid you are, the better.
However, the higher the current and liquidity ratios, the greater the proportion of resources tied up in relatively non-productive assets. This may have an adverse effect on earnings.
Therefore, it is necessary to achieve an appropriate balance between earnings and liquidity.
Current and leverage ratios
Perhaps the best-known measure of liquidity is the current ratio. This is the difference between current assets and current liabilities.
The current ratio is calculated by dividing current assets by current liabilities listed on your balance sheet.
A current ratio of assets to liabilities of 2 is considered to be acceptable (ie., your assets are twice your liabilities).
Leverage ratios indicate the amount of debt in the firm’s capital structure. Leverage ratios provide a measure of the business’ financial risk.
There are a number of leverage ratios including;
The debt to equity ratio – this ratio is total debt divided by owner’s equity (owner’s equity is the difference between the business’ assets and its liabilities);
The debt to total assets ratio – this ratio is the business’ debt divided by its total assets; and
The total assets to equity ratio – this ratio is the total assets divided by owners’ equity.
A high leverage ratio indicates that the business is in a relatively high financial risk category. A low ratio indicates that there is probably relatively cheap debt available that the business could use.
Times Interest Earned Ratio
Another leverage ratio is the “times interest earned”. This is measured by dividing earnings, before taking out interest and tax, by interest expenses.
This ratio indicates the business’ ability to service the interest payments on its borrowings. The higher the ratio, the easier it is for the business to service its debts.