Fatal Ignorance

Not Knowing Financial Ratios Can be Fatal for Your Business

“The number one problem in today’s generation and the economy is the lack of financial literacy.” Alan Greenspan

Alan Greenspan is not true for personal finance but he is also right for entrepreneurs. Entrepreneurs whose success is determined by financial performance many times do not understand the nitty-gritty of finance.

According to a recent survey by the National Financial Educators Council Americans squandered $280 billion last year due to poor financial understanding,. And financial illiteracy isn’t limited to personal finances, it is also causing new businesses to fail before they can even stand.

Financial illiteracy in India is no less alarming. Today I will write about understanding financial performance. The financial performance is not only about the profit your enterprise makes.

A good credit rating is not only necessary for borrowing money but for the health of the company also. Entrepreneurs should be sincerely interested in better credit rating in their own interest.

It is not for the lenders; it is for the business itself. Because if the borrowers are weak, it will certainly harm the lenders but the most harm is done to the business itself.

For a lender there are several borrowers, for a borrower, the business is perhaps the only business.

Analysing financial statement and the understanding of financial ratios are critical financial literacy needed across entrepreneurs.

Many times, technical superiority mindset of the technocrat entrepreneurs, make them miss the important financial understanding of the data.

In the end, it is the financial data which indicate success or failure of the business not the use of superior technology.

Here I present key critical ratios important for credit rating as well as for the financial performance of the company.

  1. Ideal Capital Structure

The imbalanced capital structure could be the beginning of the problem a business might face.

Capital Structure

Suppose your business needs Rs. 4 mn to start with, you could invest Rs. 1 mn of own fund and borrow Rs. 3 mn or

You invest Rs. 2 mn of own fund and borrow Rs.2 mn.

In both, the scenario, the operative cash flow of the business would be different. In the 1st option, the business has to bear the additional interest cost as compared to the 2nd option.

Interest cost would come down if the capital structure is Rs. 3 mn of own fund and borrow Rs.1 mn.

Your borrowing determines interest and repayment cashflow requires to service it.

There is no ideal ratio but it varies industry to industry. The high capital-intensive industry has higher debt.  But high debt increases the risk. Equal debt to equal capital is a balanced structure.

Debt to Equity Ratio = Total Outside Borrowing / Total Owners’ Capital

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  1. Debt Service Coverage Capacity

How much debt a business can service is important working entrepreneurs need to make. If the capital structure is skewed in favour of debt, it can have additional stress on the debt servicing capacity. The following three ratios

  • Interest Coverage

How many times the profit figure covers the interest payment obligation. This indicates the flexibility and stress on the cash flow to fulfill interest payment on loans.

Interest coverage ratio = Profit before depreciation, interest, and tax (PBDIT1 )/ Interest and finance charges

  • Debt Service Coverage

This ratio indicates how many times profit covers interest on loan as well as repayment of the loan within one year.

DSCR = [Profit after tax + Depreciation + Interest charges] / [Debt payable within one year + Interest and finance charges]

Anything upward of 1.5 is a healthy cushion for the business.  Higher than 1.5 makes the debt service capacity stronger.  It also indicates higher debt absorbing capacity of the ned arise.

  • Net cash Accrual to Total Debt

This is another ratio which indicates how much cash is generated as compared to the total debt obligations

NCATD = [PAT – Dividend + Depreciation] / Total debt (short and long term, including off-balance-sheet debt)

  1. Profit Margin

This is pure profit to operating income or sales ratio. This indicates how much is the profit margin after tax.

The capital structure discussed above will have an impact here. A company with zero debt will have a higher profit to the extent of interest payment on a debt for a company which has invested less of own capital and more of debt. The debt-equity ratio will have an impact on the net profit to sales ratio.

PAT/ Sales = Profit After Tax / Operating Income (Sales)

Even asset financing option and tax structure also impact this ratio.

Suppose company A decides to put up own manufacturing facility and company B decides to outsource the manufacturing.

Company A will have an investment in fixed assets, will avail loans to finance assets, and will charge depreciation on the assets in their P & L Account.

Company B only pays conversion charges.

This decision will have an impact on the PAT. Company A will have depreciation, interest, and labour charges as cost while B will have only conversion charges as cost.

Of course, the conversion charges would include outsourced company’s cost of manufacturing, etc. But the data of both company A and B would not be comparable.

Similarly, tax planning, tax zone in which the company operates, etc. impact the PAT figure.

Capital structure in-house or outsource and tax planning all are subjective decisions. In order to compare the performance of two similar companies the ratio which eliminates all these decision-centric data is known as EBIDTA/Sales.

EBIDTA Ratio = [Earnings before interest + depreciation + tax + amortization]  / sales.  

This ratio varies according to industry, country, and size of the business.

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  1. Return on Capital Employed (ROE)

Another important profitability ratio is how much a business earns on the capital employed.

This ratio helps in deciding whether to invest more in the business or reduce the investment and to look for more attractive business opportunities.

ROE = Profit Before Interest and Tax/ [Debt + Net worth]

Over the period, a business should at least be in a position to earn more than the risk-free rate of return.

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  1. Liquidity Ratio

Along with the profit, the liquidity of the business is very critical. Liquidity to the business is like Oxygen to the body. It is like a running water tap for the garden. A body or a garden won’t survive long without oxygen or water.

Business Liquidity

Liquidity determines whether the company is in a position to pay its creditors and short-term debt repayment obligation. The current ratio is broadly an indicator of the liquidity situation in the company.

Current Ratio = Current Assets / Current Liabilities

Usually, 1.33 is considered a healthy ratio. Lower than 1 is a risky situation.

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Understanding the financial statement and financial ratio both are very important skill every entrepreneur must possess.

“We were not taught financial literacy in school. It takes a lot of work and time to change your thinking and to become financially literate.” Robert Kiyosaki

You have read this post. You have taken a step you become financially literate. Hope you would be able to put to use the content in this post. All the best.

You may like to read: Why Do Entrepreneurs Need to Save for Personal Obligations?



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