Webinar 3 - Financial Ratios and Business Analysis

Finance and Ratios Discussion

Introduction

• Discussion about completing papers and the challenges encountered.
• Some found it difficult to generate ideas initially but experienced a breakthrough later.
• Learning finance is likened to learning a new language.
• Even those not in finance find the webinars interesting and well-delivered.

Ratios and Business Analysis

• The more one investigates ratios across industries, the more questions arise regarding what constitutes a good number for a specific business.
• Analyzing ratios involves a lot of thought processes and can be time-consuming.
• The speaker will discuss ratios and how they help analyze a business.

Perception of Numbers

• Many people have a negative perception or fear of numbers.
• This perception may stem from how we learn as children, connecting through touch, colors, sounds, words, and stories before being introduced to numbers.
• If numbers were connected to words, stories, or scenarios, people might connect better, but there's often a disconnect.

Financial Statements

• Financial statements are prepared to understand a business's financial performance.
• Four types of financial transactions:
  • Money comes in.
  • Money goes out.
  • Money expected to come in.
  • Money expected to go out.
• Transaction data is filtered and processed into reports and financial statements like balance sheets, profit and loss statements, and cash flow statements.
• Profit and loss statements show if a business is making a profit.
• Balance sheets explain why the profit is being made.
• Cash flow statements report when money comes in and goes out.

Analyzing Business Health

• Analyzing financial statements provides meaningful numbers to understand the pulse of the business.
• Doctors analyze health through tests; financial ratios analyze financial health.
• Ratios and findings must be communicated in simple language.
• Ideally, decisions should be made based on thorough analysis, but many bypass this due to a negative perception of finance, relying on assumptions or gut feelings.
• Analyzing a business effectively involves using ratios.

Ratios as Speed Signboards

• Ratios are like speed signboards while driving, indicating a safe speed based on road conditions.
• They help ensure business is conducted at a safe speed, allowing for informed decisions to be aggressive or conservative.
• Having ratios helps with planning, especially when $1 + 1 \neq 2$.

Business Owner's Perspective

• Business owners want to know:
  • Profitability.
  • Margins.
  • How to cut out waste.
  • Efficiency.

Investor's Perspective

• Investors want to know:
  • Return on investment.
  • Risk.

Banker's Perspective

• Bankers want to know:
  • Liquidity.
  • Cash flow.
  • Ability to pay back loans with interest.
  • The business will remain solvent for the next 3-5 years.

Key Metrics

Sales is vanity, profit is sanity, cash is king.

Profitability Ratios

• Three profit margin ratios:
  • Gross profit margin ratio.
  • Operating profit margin ratio.
  • Net profit margin ratio.
• Using "margin" implies expression in terms of percentage.
• Three return ratios:
  • Return on assets (ROA).
  • Return on capital employed (ROCE).
  • Return on equity (ROE).

Liquidity Ratios

• Current ratio.
• Cash ratio.

Efficiency Ratios

• Accounts payable ratio.
• Accounts receivable ratio.
• Asset turnover ratio.
• Capital turnover ratio.
• Inventory turnover ratio.
• Working capital turnover ratio.

Solvency Ratios

• Four categories:
  • Debt ratio.
  • Equity ratio.
  • Debt to equity ratio.
  • Interest coverage ratio.

Overview of Financial Ratios

• Financial ratios measure profitability, returns, liquidity, efficiency, and solvency.
• Profitability ratios measure profitability and returns.
• Liquidity ratios measure the ability to meet short-term obligations.
• Efficiency ratios measure efficient utilization of resources.
• Solvency ratios measure whether the business will remain solvent based on borrowed and raised capital.

Profitability Ratios Explained

• Gross Profit Margin: If the gross profit margin is $40\%$, for every dollar coming into the business, $60$ cents are paid for variable expenses, leaving $40$ cents to cover operating expenses and interest.
• Operating Profit: If the operating profit margin is $15\%$, after paying variable and fixed expenses, $15$ cents are left.
• Net Profit: If the net profit is $10\%$, for every dollar coming in, $10$ cents are the net profit, which decides how much to reinvest or distribute among shareholders.

Return Ratios Explained

• Example: A cafe has $100,000$ invested by owners and a $50,000$ loan, with a net profit of $30,000$. The total capital employed is $150,000$.
• ROA: Divide net profit by average assets. If ROA is $20\%$, every $100$ dollars invested in total assets gave $20$ dollars profit.
• ROCE: Divide profit before tax by capital employed. A $23.3\%$, ROCE means every $100$ dollars borrowed and raised generated $23.30$ dollars before paying interest and tax.
• ROE: Divide net profit by owner's equity. A $30\%$, ROE means every $100$ dollars from the owner's pocket earned $30$ dollars profit.

Comparative Analysis

• Business A has a $40\%$, ROA and a $71\%$, ROCE.
• Business B has a $20\%$, ROA and a $28\%$, ROCE.
• Business B has a higher ROE.
• Bankers might prefer business A due to higher ROCE, while investors, business B due to higher ROE.
• It is essential not to make decisions based on one ratio alone but to consider all perspectives.

Liquidity Ratios and Balance Sheets

• Balance sheets are categorized as long term and short term.
• Long term: liabilities or assets used for more than one financial year.
• Short term: liabilities to be paid back within the current financial year and assets convertible to cash within the current financial year.

Balance Sheet Types

• Type A: Long term liabilities are used only for long term purposes, and short term liabilities are used only for short term purposes.
• Type B: Majority of long term liabilities are used for long term purposes, with the amount left used for short term purposes.
• Type C: All long term liabilities are used for long term purposes, and part of short term liabilities are used for long term purposes.
• Type C is problematic because short-term liabilities are not covered by short-term assets, leading to cash flow issues.
• Type A is theoretical; it is rarely observed.

Current Ratio

• Current Ratio = Current Assets / Current Liabilities
• Experts recommend a minimum of 2. A concern if it is only 1.

Components of Short Term Assets

• Cash.
• Stock.
• Receivables.

Quick Ratio

• It is also called asset test ratio.
• Quick Ratio = Quick Current Assets / Current Liabilities
• Quick current assets include cash and receivables. Inventory is not considered liquid.
• Experts recommend a minimum of 1.

Cash Ratio

• Takes only cash and cash equivalents and divides by current liabilities.
• Cash Ratio = Cash / Current Liabilities
• Experts say that it must be between $0.5$ and $0.75$, depending on the industry.

Managing Balance Sheets

• Balance sheet B is better because it maintains a safe speed.
• However, if a startup starts in balance sheet C, they will eventually go to balance sheet B.
• Current ratio indicates the business is driving at a safe speed.
• There needs to be a plan B or C in case something goes wrong.

Circle of Control, Influence, and Concern

• Relates to business and life.
• The circle of control relates to you and what you can control.
• The circle of influence is friends and family.
• The circle of concern are external factors.
• So far, has been to control what businesses can control.

Efficiency Ratios

• Accounts receivable: Money should come in fast.
• Accounts payable: The money is supposed to go out.
• Businesses are part of an ecosystem, If someone delays payment, there will be a ripple effect.

Impact of Delayed Payments

• Large organizations delay payments to small businesses, using them as banks without paying interest.
• Imagine if the outstanding amount was decreased, the businesses would have a good cash flow.

Accounts Receivable and Payable

• Calculations determine the average period for receiving and paying money.
• A gap between payable and receivable days highlights inefficiencies and needs management.
• If it says "10", 365 / 10 = $36.5\%$, which means on average, it was on the thirty-seventh day we were receiving money from our customers.

Asset Turnover

• For every $1$, invested in assets, indicates how much revenue is generated is asset turnover.
• Also indicates how economically the assets are managed.
• Higher the number, the more efficiently assets are utilized.
• If it is $1.28$, it is saying for every $1$ dollar we invested in assets, they generated $1.28$ dollars.

Capital Turnover

• Reflects effectiveness utilizing borrowed money.
• If it is $1.51$, for every $1$ in capital, every cent dollar brings in $1.51$.

Inventory Turnover

• Reflects how quickly materials are converted to goods and sold.
• If the number is eight, the financial gear, eight times it was able to convert raw materials into finished good.
• $365/8$ = $45.6$ Indicates that for every $46$ days, the inventory was getting churned.
• If this number is high, you can compare the money with industry averages.

Working Capital

• Working Capital = Current Assets - Current Liabilities
• Efficiency in ensuring there is that cash liquidity to work with.
• Higher the number, the better for sales.

Debt Ratio

• Looks at how much debt a business can cover, based on its assets.
• Higher equity is something bankers like to see, while investors might want to see more debt.
• For instance, if the ratio is $0.54$ it shows that, for every $1$ dollar in assets, 54 cents of debt is attached to it.

Debt to Equity Ratio

• Shows how much debt is attached against the equity of the insider.
• Helps us understand how much investors have skin to the game.
• If it is $1.17$, for every investment made in every $1\%$, there is $1$, 17 cents of debt attached to it.

Interest Coverage Ratio

• The name itself says shows how much the interest is getting covered.
• It indicates how much operating profit is covered with the expenses.
• The most accurate way to calculate this is operating profit after depreciation.
• The higher of the ratio, the better managed can the business operate.

Conclusion

• Financial ratios are calculated from balance sheets and profit and loss statements.
• Begin by identifying the most relevant ratios for your business and understanding why.
• Slowly connect the dots to gain a comprehensive understanding.
• The goal is to control what we can control and influence decisions in the business world.
• Even though a business may not generate a lot of sales compared to its competitors, even though they may not be making that much of profitability, if they're really efficient, then yes, the ROE for most of the insiders will be better.
• Remember, it will be more important to see the insights than the word count of the assignments. I am willing to see you all learning how to balance both in efficiency with the data that has been provided. Remember that this information is very sensitive and remember to ask the right questions when collecting data for reports or providing feedback.