SOUTH African businessmen have come through a tough time in the past five years. They have faced high inflation, prohibitive interest rates, political upheaval and rampant violence and crime.
The general election may have changed the country, but negative factors have not entirely disappeared. Since April, we have seen strike action and violent confrontation at Pick ‘n Pay, a crippling strike in the motor industry, a continued drop in the physical volume of manufacturing production and static retail sales.
Economic and business problems lurk behind statistics thrown about by politicians, who repeatedly claim that 1995 will be rosier and better. Businessmen had better prepare for the opposite. Being well equipped can only strengthen businesses, whether its the dark days of high interest rates and bottomless government spending or better days still to come.
So how does the professional begin to assess how strong his practice or business really is? The only way is to apply a system called ratio analysis, which is the use of financial figures to build up a profile of the firm.
Once a financial profile has been ascertained, it is crucial that the professional, particularly those pressed for time (such as doctors and lawyers), understand how economic conditions can alter these ratios.
Ratio analysis is discussed in this issue, while economic terminology will be outlined in next week’s column.
No matter how small one’s firm is, you need a bookkeeper to draft a set of financial statements. The professional can insist that a number of financial ratios be included.
Among the multitude of ratios available, there are four essential issues which should be determined.
* The first is to assess whether your firm is liquid. This means that you are able to pay creditors out of present income.
The current asset ratio, which is calculated by dividing current assets by current liabilities, is the easiest to apply. Current assets are made up of the firm’s bank account and debtors’ book. Businessmen who manufacture or sell a product should include the company’s annual stock figure. Current liabilities are made up of bank overdraft, creditors’ book, short-term loans (one year) and taxation owing.
If the result of the division is less than 1,3 times, it means the firm’s short-term expenses are only marginally covered by income earned. If a major debtor does not pay, the firm could be left in an unenviable position. It could be liquidated if creditors demand immediate payment.
To increase the current asset ratio, the professional must either reduce expenses or increase current assets. This is more complicated than the professional imagines.
One doctor said the answer lies in paying for equipment in cash, which reduces the level of creditors. Maybe, but the bank balance falls, which leaves the firm in the same liquidity position. The answer centres on monthly assessments of the ratio. Experts advise professionals to keep a check on debtor payments and reduce cash spending, while maintaining creditor levels at acceptable rates.
* The second ratio is called leverage or gearing and is calculated by dividing total loans by the company’s capital base. Gearing is the extent to which loans are used to finance company assets and the higher the percentage the greater the financial risk of investing in the firm.
The problem of high gearing is more acute during times of increasing interest rates. If gearing is high, the firm will have to endure a crippling interest bill, which — in turn — reduces pre-taxed profits.
There is one school of thought which suggests that it is cheaper to finance expansion through debt than to issue shares, as in the case of private firms. This is true, mainly as issuing shares reduces your control over a firm which you’ve built up. However, professionals need to maintain gearing levels at a reasonable rate, say no higher than 25 percent.
* For the one-man operation, the third ratio is extremely important. This is the use of a ratio to determine how efficiently the firm is operating. There are two ratios, called debtor days and creditor days.
Each aims at showing the owner how long it takes to receive money from debtors and how long it takes for him to pay creditors. It is always better to receive cash at a quicker rate than one parts with it. This way the firm does not run into liquidity problems.
Debtor days is calculated by dividing the debtors’ book total by turnover, which has already been divided by 365 days. The same formula is used for creditor days.
* The fourth ratio determines the profitability of your operation. The most important one is called Return on Net Assets (RONA). It is calculated by dividing net profit (also called profit after interest and tax) by net assets.
The figure should be greater than the inflation rate, or the firm is not performing profitably.