You need to know a lot in terms of financial statement when it comes to small business accounting in order to make informed financial decisions. One of the most important things where you can start is by understanding the calculation of key financial ratios and its interpretation. Before we jump to understanding of key financial ratios it is important to do a quick refresher to three key financial statements, Balance Sheet, Income Statement and Cash Flow statement.
KEY FINANCIAL STATEMENTS
Balance Sheet provided you a look to company’s financial position on a given date. The Balance Sheet is made up of two components:
Assets and Liabilities. The liability side of a Balance Sheet includes Shareholder’s or Owners capital.
Assets is anything which company owns such as cash and bank balances, immovable assets like office premises, movable assets like equipments; machinery etc.
Liabilities side includes creditors for goods, creditors for expenses, long term and short term loans and taxes payable. The other most important part of liability is shareholders’ or owners capital which includes equity capital or owner’s capital and retained earnings.
As the name suggests, the income statement outlines your profitability over a period of time such as year, quarter or month. It is also known as Profit & Loss Account or Income & Expenditure Account. An income statement includes following:
- Total revenue generated i.e. sales
- Purchases of traded or manufactured items
- Operating expenses such as rent, salaries etc.
- Non operating expenses such as interest on loans
Cash flow statement
A cash flow statement provides picture of company’s cash inflow and cash outflow. Analysis of your cash flow is extremely important small business accounting task and must be done regularly.
Remember, cash is king. Your business could be reporting profits each month or each quarter but you may be experiencing cash crisis because your payments are not collected on time. You need cash to pay to your vendors, rents and salaries. Unfortunately you cannot pay in profits, you must have regular cash inflows.
Now since we have good understanding of financial statements, it’s time to have a look at the financial ratios. There are several different types of financial ratios but here we are going to discuss profitability and liquidity ratios. Understanding these will be a good starting point to evaluate financial health of your business.
I have added a sample income statement and balance sheet below for better understanding of ratios.
Profit and Loss Account for the
quarter ended on 30th June, 2020.
|To, Opening Stock||By, Sales|
|Mobile Phones||5,000||Mobile Phones||1,00,000|
|Mobile Covers||2,000||Mobile Covers||50,000|
|To, Purchase||By, Closing Stock|
|Mobile Phones||80,000||Mobile Phones||10,000|
|Mobile Covers||30,000||Mobile Covers||5,000|
|To, Gross Profit||48,000|
|By, Gross Profit||48,000|
|To, Non Operating
|Interest on Loans||11,000|
|To, Net Profit||35,000|
Balance Sheet as on 30th June, 2020.
|Owner’s Capital||5,00,000||Immovable Property||3,00,000|
|Cash and Bank Balances||1,10,000|
Cost of Goods Sold
Cost of Goods Sold is cost of goods that are purchased and sold. It includes opening inventory for the period, purchases for the period and closing inventory for the period.
Cost of Goods Sold = Opening
Inventory + Purchases – Closing Inventory
Cost of goods sold for mobile phones in above example is
Opening stock of mobiles 5,000
Add: Purchase of mobiles 80,000
Less: Closing stock of mobiles 10,000
Cost of goods sold for mobiles 75,000
Gross Profit Margin
margin is your earning on goods which you have sold. This simply tells you how
much money you should keep a side for future purchases on incurring a sale.
Gross Profit margin % = (Revenue – Cost
of Goods Sold)/Revenue
Gross profit margin % on mobile phones in the above example is
(Sales of Mobile Phones – Cost of goods sold for mobiles) / Sales of Mobile Phones
(1,00,000 – 75000) / 1,00,000 = 25%
This means that for every Rs.100 worth of sales, you need to keep aside Rs. 75/- to run your business smoothly.
Net Profit Margin
Net Profit margin is amount of income earned by business after payment of all the expenses.
Net Profit margin % = Net Income / Revenue
Using the above example, net profit margin % is 35000 / 165000 = 21.21%
This means that against every sale of Rs. 100 the business is earning Rs. 21.21.
Return on Assets
This ratio tells how well the management used the company’s assets to generate profits. It is calculated as below:
Return on Assets = Net Profit / Total Assets
In the given example return on assets % is 35,000/5,75,000 = 6.09%
Return on Equity / Capital
This ratio measures how much profit the company has generated using owner’s funds and is calculated as below:
Return on Equity = Net Profit / Owners’ Capital
In the given example return on equity % is
35000/535000 = 6.54%
Working capital is used to calculate short term liquidity. Working
capital is difference between Current Assets and Current Liabilities. Current
Assets include those things which are expected to be converted to cash within a
year and includes debtors, inventory, cash and bank balances. On the other hand
Current Liabilities refer to obligations which are payable within one year such
as creditors and expenses payable. Working capital can be calculated as below:
Working Capital = Current Assets – Current Liabilities
Using the above example the working capital is 1,75,000 – 40,000 = 1,35,000
Working capital is good indicator of financial stability of business. Negative working capital signal bad news for the company.
This ratio uses the same components of working capital but presents the information as ratio. Formula for current ratio is:
Current Assets / Current Liabilities
Using the example given above, the current ratio of the business is
1,75,000 / 40,000 i.e. 4.375:1
This means that for every one rupee payable the company has to recover Rs. 4.375 from market. Generally ratio of 2:1 is considered healthy. If the ratio is too high, as given in the example above, then it could mean that the company need to manage it in a better way.
Quick ratio is also known as acid-test ratio or quick assets ratio. This tells how the company can meets is current liabilities with the most liquid assets. Quick ratio excludes inventory from current assets as it is difficult to convert the inventory to cash. Here is the formula for quick ratio
Quick Ratio=(Current Assets – Inventory)/Current Liabilities
Quick ratio in the above example is calculated as below:
(1,75,000-15000)/40000 = 4:1
PUTTING EVERYTHING TOGETHER
As you can see, the calculation of financial ratios is not too difficult. It is just pulling out some data from your financial statements and computing as per formulas. However, it is important to note that the financial ratios don’t tell you much on their own.
To have a full view of your business performance you need to know that your business does not operate in vacuum. Therefore it is advisable to take into consideration the industry data for analyzing your financial statements. Having a quick ratio of 4:1 might seem a bad idea but if the industry standard happens to be 5:1 you need to work on it.
You may also note that the banks and financial institutions use these ratios on assess how likely a business would be to default a loan. Knowing how to calculate the ratios is one thing, working to improve the financial report using the ratios is another.
At this time getting help from an experienced accounting services company is advisable. Hiring an in house resource for accounting who can help you to improve your financial report can be costly. On the other hand using services of Ofin saves you time and money allowing you to focus on your core business. With outsourced accounting services from Ofin you don’t have to worry about improving your financial statements, you have enough to worry about your own business.