Understanding Key Financial Ratios | Think Accounting Think OFIN

Understanding Key Financial Ratios

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

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.

Income Statement

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:

  1. Total revenue generated i.e. sales 
  2. Purchases of traded or manufactured items
  3. Operating expenses such as rent, salaries etc.
  4. 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.

FINANCIAL RATIOS

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.

ABC Enterprise

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    
      1,65,000  

1,65,000

To, Operating
Expenses
  By, Gross Profit 48,000
Rent 5,000    
Salaries 2,500    
Utility Payments 1,500    
To, Non Operating
Expenses
     
Interest on Loans 11,000    
To, Net Profit 35,000    
 

55,000

 

55,000

ABC Enterprise

Balance Sheet as on 30th June, 2020.

Liabilities   Assets  
Owner’s Capital 5,00,000 Immovable Property 3,00,000
Retained Earnings 35,000 Equipments 1,00,000
       
Creditors 25,000 Debtors 50,000
Expenses Payable 15,000 Inventory 15,000
    Cash and Bank Balances 1,10,000
 

5,75,000

 

5,75,000

Profitability Ratios

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

Gross Profit
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%

Liquidity Ratios

Working Capital

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.

Current Ratio

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

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.

Click here to schedule a 30 minutes free call to improve your financial statements.

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