I am an accountant. Unsurprisingly I don't mind playing with numbers. Since you're in business, you probably play with numbers less, but still too often for your liking. Usually, our articles present an overview, suggesting some directions for further investigation. This month we've had no option but to split it into two articles (the second will follow next month), but even as it is we only deal with a summary of an enormous area. However, there are two parts to this topic. The first is looking at why we should be familiar with the numbers that drive our business. Next time we'll look at the mechanical issues - getting numbers out - and what they can tell us.
But why? Why produce numbers? At best, it can so easily be an added chore with no real point. Or it could be the start of changing your business. If you are a cash-only business producing debtor reports will be simple and useless. Similarly, if you don't have stock, there's no point wasting time on stock figures. I'd agree with you that numbers are of no use if they don't actually tell you something that will make a difference. Choosing the right numbers to produce is key.
Introduction
While most business owners know the technical details of their products well they know very little about finance and yet money is the lifeblood of the business - being ignorant of how finance works can lead to business failure. I’m sure I don’t have to convince any of you that making a profit is the key part of what business is all about. No profit – no business. And yet if I asked you “If you increased your sales by 25% to 50% over the next six months, what would happen to your cash balance?” would you be able to tell me? Rarely would one in ten SME owners be able to answer that question.
But not knowing that, as I will demonstrate later, could land you in a deal of trouble with unpaid bills and a cash flow crisis even though sales have increased and the bottom line is looking rosy.
Now, if I asked you a technical question about your line of work I’m sure you’d have no trouble giving me the picture and the consequences of various decisions. And yet, where we are talking money - the very lifeblood of the business - owners are often ignorant of the facts of business life.
Why you need to be able to ‘read’ your basic financial statements
The first part of this article is an attempt to interest you enough in your financial records to take the step of learning about the various ways your figures can be sliced and diced to give some useful information about how your business is running. That is, how to take the basic money documents of business, your balance sheet and a few basic financial ratios, and read them for what they tell you about your business operations. That covers the first two of four points. We'll look at the remaining two next time.
- Demystifying financial ratios – what they are and what they can tell you about your business’ performance
- The different types of financial ratios – what they are used for
- Examples of what some of the ratios can tell you about how your business is performing
- Using ratios for benchmarking and tracking performance
Financial illiteracy
If you can’t read and understand your financial ratios then you may be a financial illiterate. Strong language - but accounting is not the favourite subject of many business owners and that goes for businesses of all sizes. Many a CEO of a large business can’t ‘read’ their financial ratios – though luckily, there, they have a CFO or an accountant to do it for them and tell them what the figures mean.
For many smaller businesses the owner gets their income statement each month and sweats while checking the bottom line – is there a positive margin between costs and income? And that’s it – that’s all that those figures mean to them.
Not knowing how the business is going financially is a common prelude to business failure. Understanding accounts figures is not complicated - an SME can be managed with a relatively simple set of financial reports such as the balance sheet and the profit and loss statement. In fact, across SMEs as a whole, not knowing how their business is going financially is a common prelude to business failure. And it's not as if you need to do anything complicated.
What's the problem?
In my experience, when trying to convince business owners to take more interest in the financial ratios of their business I get two common objections:
- Lack of time to gain an understanding
- But also, when it gets honest, the whole subject looks like so much difficult jargon and hard-to-understand terms
I want to dispel both of those ideas. I will cover some basic concepts in this article – though I’m not going to overload you with them. I just want you to appreciate the possibilities. And I’ll use straightforward language to demystify them.
Lack of time
So, you’re too busy to learn Finance 101? Put aside your misconceptions of finance and take the time to learn about the workings of your ratios – your business could depend on informed financial decisions
Agreed, you are busy people what with the pressures of running the business, getting customers, keeping them satisfied, and dealing with the day-to-day crises that occur. That may leave you little time to fret over debits and credits. And if each month the news on the bank statement is good, with cash rolling in, then do you need to bother?
All I can say is that’s not a wise approach to management. You’ll appreciate that as soon as the news is not so good - if the bottom line is red instead of black; if your bank refuses you a loan; if suddenly you can’t meet a creditor’s account on time or whatever.
If you are losing money, you need to know it while there is time to get back on track. And even if you are doing well, your financial ignorance could mean you are losing opportunities to be even more profitable. My advice and I hope this article will demonstrate the value of it, is to put aside your misconceptions of finance and take the time to learn about the workings of your ratios.
The language is difficult
The second main turn-off is language. I admit it - often the terminology used by accountants ourselves is part of the problem. Even the term ‘financial ratio analysis’ itself sounds pretty complicated. And then we get to terms like ‘Return On Equity’, ‘Activity Ratio’ and the ‘Accounts Receivable Turnover’.
Sometimes definitions don’t help too much either – here’s one for Return On Equity: A measure of how well a company used reinvested earnings to generate additional earnings, equal to a financial year’s after-tax income divided by book value, expressed as a percentage.
Problem: Finance sounds even more complicated than it really is.
Do I really need to know that?
Yes – translated into ordinary English, financial ratios can give you essential insights into your business’ performance. Who needs to spend time figuring out what that means? Well, you may. Because translated into what you are doing, what you are working for day after day, your ROE translates as ‘Am I getting a return adequate to make all this effort and worry worthwhile?’ It's one of the most important ratios you can know.
It shows a really hard fact about your business - are you making enough of a profit to compensate you for the risk of being in business? Would you believe that for some businesses the ROE is so low that they might as well sell up and put their takings into a reliable investment portfolio to earn just as much as they are clearing working day after day?
All financial ratios can be translated into simple concepts like that. The trick is to think about them as nothing more than ‘batting averages for businesses’.
Types of financial ratios
- Liquidity Ratios: does the business have enough money to pay its bills?
- Efficiency Ratios: compared to its assets and capital employed, has the business made a good profit?
- Profitability Ratios: has the business made a good profit compared to its turnover or capital invested?
- Solvency Ratios: does the business carry a lot of debt and how vulnerable is it to risk?
As batting averages, they can tell you how different parts of your business are performing. So before we go further let’s step back and look at how financial ratios can be grouped to demonstrate the performance of particular aspects of a business.
Commonly you’ll hear the four different kinds mentioned, so we'll expand each a little.
Liquidity ratios: as the name suggests, these help measure how liquid a business is – what your capacity is to pay your debts as they come due. So they are commonly used by bankers and suppliers to measure how creditworthy you are. But you can also use them to help uncover potential threats to your financial position.
Efficiency ratios: these reflect the efficiency of your business operations. They deal with cash flow, inventory, and how quickly your products or services sell. They can be used for such things as judging how well your collections policy is working by analysing your business’ receivables turnover ratio or your average collections period.
Profitability ratios: these ratios measure the ability of your business to make a profit. They deal with sales, cost of goods sold, profit margins and others that show if you are maximising the bottom line.
Solvency ratios: these are indicators of the businesses' vulnerability to risk. These ratios are often used by creditors to determine the ability of a business to repay loans.
If you don’t manage and plan ahead and make decisions using your accounts ratios you are driving your business without the gauges that tell you how you are going
Dashboard Gauges
Now, say you had some of these figures produced regularly – what use would they be? As a starter, it’s useful to look at them in a particular way – as gauges. What if you started to see these figures like a set of dashboard lights like the ones on your car? The gauges there indicate a few of the most critical elements for ensuring the proper working of the vehicle – petrol to make sure you can get to your destination; temperature so you stop before seizing the engine; speed so you stay within the limit. The movements of the gauge needles tell the story – are things OK or are they alerting me that unless I do something the car will stop, be damaged or get me fined for speeding?
That’s what financial ratios are like for a business. If you don't manage and plan ahead and make decisions using your accounts ratios you are driving the car without the gauges that tell you how you are going.
Business accounts show a profit and sales are up – but there’s not enough cash to buy stock to meet demand or to pay for the employee’s wages. It’s a mystery – or is it?
Using Ratios To Plan – An Example
With a few gauges, you could have forecast this situation, identified what was causing it and manoeuvred around it.
Say you kept tabs on Days In Receivables. When that creeps up you know it's taking longer to get paid by debtors. So you get a warning – a chance to investigate the reason. Is it because some debts are ageing and becoming doubtful? The longer you take to collect debts the higher the risk of never being paid. So – take steps to speed up collection; you want as low a days' receivables ratio as possible because it represents cash to build your company as opposed to finance for your customers.
Other gauges might be measuring your working capital ratios, and they could point to the problem coming from tying up too much cash in stock. So – sell off obsolete stock and get some return; or run a check on just how much stock you need to keep and trim it down to that.
Next article we'll delve into some of the most commonly used sorts of ratios, and what you might do with them.