Business Accounting

This article deals with the business accounting ratio for assessing the LEVERAGE or gearing of a company Essentially, the Leverage Financial ratio should be able to measure the amounts of borrowed money being used by the firm.

Leverage Ratios are classified as either:

• Capitalization Ratios, focusing on how investments are financed; or
• Coverage Ratios, focusing on the ability to service the firm’s sources of financing.

The following financial accounting ratio is for the assessing the activity of assets deployed by the company. Essentially, the activity ratios measure the efficiency of managing or using of assets like

• total assets,
• accounts receivable,
• inventory, and
• accounts payable.

Below demonstrates using the overall/total assets to company’s total sales. However, you can apply the aforesaid individual assets against the company’s total sales to understand which assets have been best or under utilised by the company.

The following financial accounting ratio helps to measure the bottom-line results or the profitability of the company.

Some typical major profitability ratios are:

• Gross profit & Net profit margin,
• Return on Total Assets,
• Return on Equity.

Let’s look at the financial ratio for assessing the liquidity of a company. Liquidity means the firm’s ability to satisfy its short-term obligations as they come due.

Two typical ratios are recommended:

• The Current Ratio, and

• The Quick (Acid-Test) Ratio.

Tabulated as follows for easy reference:

As managers whether with or without financial accounting knowledge, it’s important to understand really what is financial accounting ratio analysis. We need to understand that like any analytical tools, it has benefits and of course certain limitation.

Append below are some frequently/commonly asked questions on Financial Accounting Ratio Analysis:

Using common size methodology to analyze the financial statements like the Income Statement and Balance Sheet are extremely useful as it removes bias particularly when the companies are of differing sizes. Common financial statements enable us to do easy analysis between companies or between time periods of a company. It allows us to analyze the company over various time periods, revealing, for example, what percentage of sales is cost of goods sold and how that value has changed over time or what percentage of total assets is inventory/receivables and how that value has changed over time. So what is really common size financial statements?

Common size methodology is simply displaying or formatting all items whether in the balance sheet or income statement as percentages of a common base figure.

In the case of an income statement, the common base is the revenue whilst in the balance sheet it can be the total assets/total liabilities.

Common size financial statement is one of the principal tools used in ratio analysis as most firms don’t report their statements in common size, it is beneficial to compute if we want to analyze two or more companies of differing size against each other.

Let’s look at a simple Income Statement – a normal one and then compared with a Common size : A normal Income Statement

Translated into a Common Size Income Statement

After the re-format / display into common size income statement, we can see how the various components of the income statement affecting the company’s profit.

Line (1) – gross profit have improved from 27.3% in 2005 to 33.3% - why?

Line (2) - operating costs also improved from 10% to 6.6% - why?

As a result now we know what caused the improvement in operating profit

But what is this “ other incomes” under Line 3 from a meager 0.5% have rose to 4.% of total revenues?

Is it common for this type of company to have such high other income – is it exceptional re: one time affair which might distort the profit before tax.

If we want to delve further, we should go into details into the operating cost (line2) or we can put up a detailed financial statement for inter-companies comparies.

Next what about the common size Balance sheet :

With a common-size balance sheet that displays all items as percentages of a common base figure like total assets, it assist us to perform analysis between companies or between time periods of a company.

Simple Illustration:

A normal Balance Sheet

Translated into a Common Size Balance Sheet

The above illustrates the difference between a regular balance sheet and a common size balance sheet.

Salient points:

• In the normal balance sheet, account values are expressed in dollar terms, while

• in the common size one, each value is listed as a percentage of total assets.

• This is also done for liabilities, where each liability account is a percentage of total liabilities

Reviewing the common sized balance sheet, line 1-3 showed a drastic decline of holding cash and more investments into inventory and receivables.

This article deals with some of methods/techniques to analyze the financial statement.

They include the following:

1. Comparative Financial Statements – Year to year changes

2. Index Number Trend Series
3. Specialized Analysis
4. Common - Size Financial Statements
5. Ratio Analysis
   

1. Comparative financial statements -Year to year changes This analysis is very commonly used however there are certain basic rules we  need to understand/avoid: 

Rule No.1:-

• when a negative amount appears in the base year and a positive amount in the following year or vice versa no percentage change can be meaningfully computed.
   

Rule No.2:-

• When an item has a value in a base year and none in the following period, the decrease is 100 percent.
  

Rule No. 3:-

• Where there is no figure for the base year, no percentage change can be computed.
  

Simple Illustration:

                                 Year 1      Year 2        $            %

Net income/(loss)    (4,500)      1,500      6,000         -         

Tax expense              2,000      (1,000)   (3,000)        -

Notes payable              -            8,000      8,000         -

Notes receivable      10,000          -        (10,000)    (100)

Next, we move to the second method which is the

Index-Number Trend Series

When a comparison of financial statements covers more than 3 years method no 1- Year to year method of comparison may become too cumbersome.

The best way to effect such longer-term trend comparison is by means of index numbers. The computation of a series of index numbers requires the choice of a base year that will, for all items, have an index amount of 100. since such a base year represents a frame of reference for all comparisons, it is best to choose a year that, in a business condition sense, is as typical or normal as possible. If the earliest year in the series compared cannot fulfils this function , another year is chosen. As is the case with the computation of year-to-year percentages changes, certain changes, such as those from negative to positive amounts, cannot be expressed by means of index numbers. All index numbers are computed by reference to the base year.
In planning an index-number trend comparison, only include the most significant item. 

Care should be exercised in the use of index-number trend comparisons because such comparisons have weaknesses as well as strength.

 For the specialized analysis method, this includes like:- 

• Cash forecasts
• Analysis of changes in financial position
• Statement of variation in gross margin
• Breakeven analysis
  

The next article is on Common-Size Financial Statements which will enable readers to properly analysis and interpret financial statements.