Importance of an Accountant’s Perspective:
Understanding finance of the business from an accountant’s view is like doctors’ perspective on a medical report. Both financial report and medical report shows variety of data and information, but it will be most fruitful when gone through the eyes of an accountant and doctor respectively. Accountants helps in understanding the financial metrics of a business such as profitability, growth, cash flows etc. These expert opinions then help in achieving major business performance and business strategical direction. Such valuable viewpoint creates canvas showcasing businesses past performance, present status, and future potential.
Key Financial Metrics for Measuring Business Performance:
1) Profitability Metrics:
a) Gross Profit Margin (GM):
It is calculated as the percentage of Gross Profit (GP) to total revenue or sales (GM = GP / Sales).
Gross Profit is difference between total revenue or sales and cost of goods sold (COGS). (GP = Sales – COGS)
High GM indicates good controlling of company on its costs of goods sold (COGS).
It shows how efficiently, a company is generating profit from sales.
It helps in understanding how we are performing compared to our industry peers.
As this is gross margin, it excludes the indirect expenses thus does not provide a complete picture of company’s profitability.
b) Net Profit Margin :
It is calculated as the percentage of Net Proft (NP) to total revenue or sales (NM = NP / Sales).
Net Profit is profit after deducting all the expenses from revenue or sales. (NP = Sales – All Exp.)
It is an important financial metric which shows how good is company in generating maximum profits by controlling its expenses.
A low net profit margin warns company about high operating cost, poor pricing strategies or any other challenges which company might be facing.
It is one of the important financial metrics which help an investor to decide whether to invest in the company or not.
Analysing own Net Profit Margin trends (Past to Present) and comparing the same to the industry standards, helps in effective decision making which keeps a company a step ahead of competitors.
c) Return on Assets (ROA):
Return on Assets or ROA means how much company is earning in percentage of its average total assets. (i.e. ROA = Net Profit or Earning / Average Total Assets).
Average Total Assets is nothing but mean of total assets during a certain period usually annual.
ROA mainly shows 2 things, first, how effectively a company is using its existing assets and secondly, has company made any excess investment in existing assets.
Higher ROA indicates that a company is deploying its assets effectively to gain maximum profitability.
By optimising ROA at fullest, companies earn more from its existing assets. This then helps them to expand without taking outside fund.
Analysing and comparing ROA with competitors helps a business to understand their overall performance of utilisation of its existing assets.
d) Return on Equity (RoE):
RoE in simple words is how much a company earns in percentage of its equity amount (RoE = Net Profit / Equity).
Equity means company’s own contribution in the business or in other words Total Assets minus Total Liabilities.
RoE helps in understanding profitability of the business.
Higher RoE indicates optimum utilization of equity.
Comparing RoE with competitor with similar level of debt or leverage helps us to know whether we are performing good as per industry standards or not.
2) Liquidity Metrics:
a) Current Ratio:
It is calculated as Current Assets divided by Current Liabilities.
Current Assets are the company’s assets which can be realisable within a year whereas current liabilities are the liabilities which are to be paid off within a year.
It tells whether company’s short-term liquidity can cover its short-term liabilities.
Higher the ratio means better the company’s short-term financial standing.
Good Current Ratio shows company has better liquidity which is one of the important financial metrics to attract more investors.
It helps the creditors to evaluate company’s credit risk.
b) Quick Ratio:
It is calculated as Quick Ratio = (Current Assets – Inventory) / Current Liabilities.
Contrary to Current Ratio it excludes inventory from current assets which is not easily converted to cash.
It shows us the ability of company to cover its short-term obligations.
It is more conservative compared to current ratio.
If its more than 1 then one can say the company has very strong short-term financial standing.
3) Efficiency Metrics:
a) Inventory Turnover:
It indicates how much times company’s turnover or sales is compared to its inventory or stock.
Inventory Turnover = Sales divided by Average Inventory.
This financial metric helps in understanding the turnaround time of an inventory to sales.
For example, if Inventory Turnover is 5 it means that:
Total sales is 5 times the average inventory.
Average inventory is equal to 73 days of sale (365/5).
It takes 73 days to completely sells off the average inventory.
This ratio when compared to our peers helps in understanding,
how are we performing in terms of sales time of our inventory?
are we holding more inventory compared to our competitors.
Higher ratio indicates more investment in inventory.
b) Accounts Receivable Turnover:
It indicates how much times a company’s turnover or sales is when compared to its accounts receivables.
Accounts Receivable Turnover = Sales divided by Average Accounts Receivable (AR).
This financial metric helps in understanding the turnaround time of an AR to sales.
For example, if Accounts Receivable Turnover is 5 it means that:
Total sales is 5 times the average accounts receivable.
Average Accounts Receivable is equal to 73 days of sale (365/5).
It takes 73 days to completely realise the payment from Accounts Receivable.
This ratio when compared to our peers helps in understanding,
How are we performing in terms of sales credit policy? Whether it is properly followed?
Are we realising our accounts receivable in due time?
Whether we need to change out credit policy?
4) Solvency Metrics:
a) Debt-to-Equity (D/E) Ratio:
It is calculated as DE Ratio = Total Liabilities / Total Equity.
It means how much outside liabilities a company has compared to its own equity.
For example, if Debt Equity Ratio is 2 it means that:
Total outside liability is twice the company’s own investment.
Out of total assets company owns 33.33% (i.e. 1/3) and outsiders owns 66.67% (2/3).
The company is reliant on borrowed capital for its continued operation.
Lower the D/E Ratio less reliance on borrowed capital which will be good sign to attract potential investors.
Higher the D/E ratio more reliance on borrowed capital. It doesn’t mean bad thing as the startup usually borrow more fund during initial period.
But if matured business has high D/E ratio compared to its peers in industry, it might be the indication overly rely on debt and might go into financial trouble if earning disturbed.
b) Debt Service Coverage Ratio (DSCR):
It is calculated as DSCR = Profit Before Interest & Depreciation (PBDT) / Total Debt Service. (Total Debt Service = Interest + Principal)
It means the times company’s cash profit before interest to its debt service.
For example, if DSCR is 3 it means that:
Company’s Cash earning is 3 times to total debt to be served.
Company can easily honour or pay its all-debt obligation.
If company has debt-obligation of 10000 then it’s PBDT is 30000.
Higher the DSCR lower the chances that company will default its debt service.
Lower the DSCR less likely the company will serve its debt obligation.
DSCR is the financial metric on which an investor as well as borrower rely as its shows the standing of a company’s ability to pay the debt obligations.
c) Interest Coverage Ratio:
It is very much like DSCR. Here only interest part is considered while calculating ratio.
Thus, it will always be equal or greater than DSCR ratio.
It is calculated as ICR = Profit Before Interest & Depreciation (PBDT) / Total Interest Obligation.
It means the times company’s cash profit before interest to its total interest.
For example, if ICR is 3 it means that:
Company’s Cash earning is 3 times to total interest to be served.
Company can easily honour or pay its interest obligation.
If company has interest obligation of 10000 then it’s PBDT is 30000.
Higher the ICR lower the chances that company will default its interest obligation.
Lower the ICR less likely the company will serve its interest obligation.
ICR is an important financial metric when a company is obligated to serve only interest portion on its debt (Eg.: Working Capital Loans or Cash Credit Loans).
5) Cash Flow Metrics:
a) Operating Cash Flow:
It means how much cash is generated from company’s normal operation during a specific period.
Operating Cash Flow = Net Operating Income (+) Non-Cash Expenses (-) Increase in Working Capital.
Non-cash expenses refer to provisions of expenses or expenses incurred on credit which doesn’t impact actual cash hence added.
Increase in working capital refers to increase in current assets forming Accounts receivables and inventory. Thus, not realised in cash hence reduced.
This will not include non-operating or other income such as interest or rental income.
This financial metric helps a potential investor to understand how much cash a company is generating from his operations.
Higher the operating cash flow better the cash stability of the company.
It helps in determining the company’s primary source of income and how much it is generating cash from its primary source.
b) Free Cash Flow (FCF):
The free cash flow as its term say is free amount of cash a company left with after all the application of cash (i.e. including reinvestment in operation) but before any payments to share holder or bond.
Thus, it can be calculated as Free Cash Flow = Operating Cash Flow (-) Capital Expenditures.
Free cash flow is used majorly to pay dividends to the investors or buy backing of company’s own shares.
Higher the FCF stronger the company’s financial standing.
This increases confidence of investors or stake holders in the company.
How above financial metrics will improve major business performance:
Applying financial metrics can improve the major business performance and helps in taking effective decisions.
Analysing Profitability Metrics such as Gross profit margins or Net profit margins, company can improve cost efficiency which will lead to better operational strategy for enhanced profitability.
Efficiency metrics such as Inventory Turnover or Accounts Receivable Turnover will help in reducing wastage of resources and money. Optimising it will also streamline the business operations which will lead to making of better credit policies and its effective implementation.
Solvency Metrics like DE Ratio, DSCR and ICR will help in understanding the company’s financial position. Proper watch on it will help in effective decision making in relation to borrowings and its repayment. This will increase the profit as well as company’s financial stability.
Comparing these metrics with industry standards and business peers, will help a company to identify its weaknesses and improve the same. This will also give competitive advantage to the company.
Applying these financial metrics empowers effective as well as efficient data driven decision making. This will help management to align their operations with strategic goals for sustainable growth.
Financial Analysis with the help of Technology:
Latest software and applications play an important role in modern accounting.
Efficient use of it can provide you with various reports to analyse business in depth.
Cloud based and mobile accounting enables business owners to analyse business at anytime and anywhere.
These software converts large volumes of data into useful reports which an accountant can analyse and help the business owners to take decisions in improving the business performance and growth.
Accountant’s Perspective:
The business owners who want to fully utilise the financial metrics of their business can enter partnership with an accountant. They can help them to truly understand the financial metrics at its full potential and help them to make efficient data driven decisions. Don’t let your business face the complexity of financial metrics alone, an accountants perspective can make the path easy so that you can do the best what you do i.e. your business.
Comments