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How to Use Financial Ratios in Analysing Business Accounts

It is an essential analytical skill for anyone involved in accounting and financial management to make effective calculations. It is important to know what to collect, how to collect and what the end result really tells you.

Take the example of buying a new car. If we wanted to compare performance levels between cars, we wouldn’t usually look at features like the size of the steering wheel or the efficiency of the windshield wipers. We use it to look at such metrics as miles per gallon, miles on the hour, time since its last service, etc.

The same approach can be applied to businesses and their published accounts. All the information we need can be found in the Balance Sheet and the Profit and Loss Accounts. All we have to do is look at some established financial ratios (MPG financial equivalent) and understand how to calculate and use them.

We will now give two examples of ratios and discuss how they can help you analyze the performance of a business.

Current Rating

In our previous article “Understanding Working Capital in Financial Management” we discussed the importance of working capital and its accounting which was:

Current Assets – Current Assets = Working Capital

The above calculation will give a monetary value. This is very difficult to compare with other businesses, and indeed previous years because the trading conditions are unique from business to business, year to year.

For example, how much working capital (in terms of cash) should a large supermarket have compared to a corner store? A difficult question to answer without more information.

However, look at what happens when we rearrange the equation:

Total current assets / Total current liabilities

This is called the “Current Ratio” and is an important indicator of how liquid a particular business is. Now it is much easier to take an assumption like “All major supermarkets have at least a current ratio of > 2) and quickly calculate the ratio for a number of supermarkets.

Rate of Return on Capital Employed (ROCE).

Many people use profitability to analyze a company’s performance. Again, this is not as easy as it seems. Imagine your reaction if I told you I made 20,000 Euros from selling a house. You may be impressed at first. How would your reaction change if I told you then that my house was worth 600,000 Euros?

The “Return on Capital Employed” ratio is a great way to understand how well a business has been operating and converting its resources into profit. It is calculated as follows:

Return on capital employed = Profit / Shareholders’ equity * 100

This is a very important ratio and many people use it when considering investment decisions. How much did a company make for its investors last year? Was it a better investment than other companies or opportunities available like bonds, stocks or savings accounts?

We can adjust the rate for our home seller a bit like this:

ROCE = 20,000 / 600,000 (investment amount) * 100 = 3.33%

Consider rates in their broader context

So you can see, making a profit of 20,000 Euro is not as interesting as you think at first. Other issues such as investment duration and general market conditions can compound the problem.

This is equally true of ROCE ratios and any ratio in general. It’s a starting point, a useful tool for comparison, but ratios should never be used to make sweeping assumptions.

Combine Quantities for Informed Analysis

Using two (or more) ratios together is a good way to get a better picture of the situation. They say we calculate ROCE 10%. This looks very good and we are interested in investing. However, the current ratio comes out at 0.25 and shows that current liabilities are 4 to 1 greater than current assets. This would be an indication that the business has serious liquidity concerns and may freeze our interest.

It is also worth noting that published financial statements are “snapshots in time” and may not accurately reflect the current trading situation of the business.

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