Being able to make effective comparisons is a key analytical skill for anybody involved in financial accounting and management. It is important to know what to compare, how to compare and what the end result actually tells you.
Take the example of buying a new car. If we wanted to compare performance levels between cars we would not usually look at features like the size of the steering wheel or efficiency of the windscreen wipers. We are used to looking at such metrics like miles per gallon, miles on the clock, the time since its last service etc, 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 Profit and Loss accounts. All we need to do is to look at some established financial ratios (the financial equivalent to MPG) and understand how to calculate and use them.
We shall now example two ratios and discuss how they can help you analyze a business’ performance.
The Current Ratio
In our previous article “Understanding Working Capital within Financial Management” we discussed the importance of working capital and its calculation which was:
Current Assets – Current Liabilities = Working Capital
The above calculation will give a monetary value. This is quite hard to compare with other businesses, and indeed previous years as the trading conditions are pretty unique business to business, year to year.
How much working capital (in cash terms) should a large supermarket have compared to a corner-shop for instance? It’s a hard question to answer without knowing a lot more information.
However, observe what happens when we re-arrange the equation to:
Total Current Assets / Total Current Liabilities
This is called the “Current Ratio” and it is a great indicator of how liquid a particular business is. It is now far easier to follow an assumption like “All large supermarkets should at least have a current ratio of > 2) and quickly calculate the ratio for a number of supermarkets.
Return on Capital Employed (ROCE) Ratio
Many people use profits to analyze a company’s performance. Again, this is not as straightforward as it seems. Consider your reaction if I told you I made 20,000 Euros on the sale of a house. You might at first be impressed. If I then told you the value of my house was 600,000 Euros how might your reaction change?
The “Return on Capital Employed” ratio is a great way to understand how well a business performed turning its resources into profit. It is calculated as follows:
Return on Capital employed = Profit / Shareholders funds * 100
This is a very important ratio and many people use it when considering investment decisions. How much did a company make last year for its investors? Was it a better investment than other companies or opportunities available like bonds, commodities or saving accounts?
We can adjust the ratio slightly for our house seller as follows:
ROCE = 20,000 / 600,000 (the amount of investment) * 100 = 3.33 %
Consider Ratios in their Wider Context
So you can see, making a 20,000 Euro profit is not as impressive as first thought. Other issues like the length of investment and the overall market conditions can cloud the issue.
This is equally true with the ROCE ratios and any ratio in general. It is a starting point, a useful tool for comparison but ratios should never be used in isolation to make concrete assumptions.
Combine Ratios for Informed Analysis
Using two (or more) ratios together is a good way of getting a better picture of the situation. Say we calculate a ROCE of 10%. This sounds pretty good and we are interested in investing. However, the current ratio comes out at 0.25 and signals the current liabilities outweigh the current assets by 4 to 1. This would be a sign that the business has serious liquidity concerns and should probably cool our interest.
It is also worth noting that published financial statements are “Snapshots in time” and might not accurately reflect the current trading situation of the business.