Your 3 best friends…financially speaking

 

 

There is safety in numbers but if 98% of statistics are made up can you trust all numbers equally?  When analysing your business results any business owner knows that ‘cash is king’ but what other clues can you look for to assess the success your financial decisions are having on your business results?  We look at three key financial ratios you should use to measure your success.

Art not Science

Accountancy is art, not science, so there are three helpful numbers that can give us some blinding insight over and above what the bottom line is telling us.  And if you disagree then revisit the story of Carillion, which posted not only profits but share dividends the year before it collapsed.

Start by gathering your balance sheet and income statement (or Profit and Loss report).  You can use your last full year’s reports but ideally take your last 3 years reports and use the average number.

Next pull out the numbers for:

  1. Total Assets (balance sheet)
  2. Total Liabilities (balance sheet)
  3. Total Shareholder Funds (balance sheet)
  4. Total Shareholder Equity (balance sheet)
  5. Net Income (income statement)

In short the 3 numbers we are about to calculate give you a view on a company’s:

  • Strength
  • Performance
  • Resiliency

 

‘Strength’ or Debt-to-Equity ratio

To grow your business you have three fundamental options.  You can source your growth from cash.  You can take on debt through loans from creditors (i.e. the bank) or you can ‘sell’ some of your equity to new shareholders in the share capital or ‘debtquity’.

Your debt to equity ratio is a good measure of your company’s strength as high levels of debt when compared to your shareholder funds show that your business is highly geared or ‘leveraged’.  The higher your gearing, the more restricted you will be on raising further debt and the more expensive that debt will be particularly if sourced as debt instead of equity.

So, you calculate your debt-to-equity ratio as:

total liabilities/total shareholder funds

A ratio of 1.0 is risky, a ratio of less than 1.0 is better.  There is a situation that can skew this ratio though – remember ‘accountancy is an art, not a science’ and so a business that has few assets on the balance sheet and high levels of goodwill recorded can look risky but be fine.  This may be the case with a professional services company as an example.

Having no debt isn’t necessarily a good thing either though.  It’s what you do with it that counts, which is what our next ratio measures.

 

‘Performance’ or Return on Equity

A top line revenue or sales figure is important but if it costs you more money to get the sales then that’s not good business.  This is one of the prime reasons we dislike sales incentive schemes that focus on sales figures only.  It incentivizes pursuit of revenue over profit.

Your net income number is of course the money that is left over after all the fixed and variable costs of the business have been paid but before any dividends are made.  Next your shareholder equity should be the funds that are building in the business as you operate.  You will build shareholder funds by increasing the asset value of your business and minimising the liabilities.  So it follows that the net income should be as a result of putting your liabilities to work to build assets.  If you are not doing this you will be depleting your assets to service your liabilities.

The measure of performance or return on equity is:

net income / total shareholders’ equity

This measure returns a percentage.  Something like 10% is a good return as it measures up to the return you might get if you placed the same amount of cash into a savings account.  One off lower returns may be explainable through what we call exceptional items but a pattern of low returns suggests that something fundamental is wrong in the business.

 

‘Resiliency’ or Current Ratio

Sometimes referred to as the ‘Gearing Ratio’ this measure essentially tells you the degree to which the company is funded by creditors versus shareholder funds.  The thinking is that a creditor can call ‘in’ their debt at any time whereas shareholder funds are for life.

The Current Ratio is calculated thus:

current assets/current liabilities

You are looking for a ratio of MORE THAN 1.0 on this measure (unlike the Debt-to-Equity ratio) which essentially means that your assets outweigh your liabilities and translates to their being some form of ‘value’ in your company.

What we call ‘flow through’ or ‘lifestyle’ companies won’t necessarily have good ratios but if you are using your business as part of your retirement strategy you need to build value in your business.  Value for any investor means your business is strong, performs well and is resilient.  And it is a combination of the three measures that builds maximum value.