Part
Ten - Annual Accounts/ Ratios and Trends
If
there is any business borrowing from a bank,
generally the banks will want to see the annual
accounts. They want to see them for the obvious
reasons and the more straightforward comparisons,
like, Sales, Gross Profit and Net Profit and
that the business is still viable as a going
concern.
But
before we even get that far you have to remember
that the banks want the annual accounts produced
in a timely fashion, realistically within
six months of balance date. The directors
should also sign the annual accounts to confirm
they believe the accounts are an accurate
representation of the year's results.
This
is commonly missed and that makes me wonder
how many other directors' responsibilities
are missed.
I'd
like to run through some ratios the banks
use, and their importance.
Profitability
Ratios
Sales
Growth
Total Sales (current period) - Total Sales
(prior period) = Sales Growth
Total Sales (prior period)
Banks
will look at sales growth to determine if
the company's sales are going up and whether
the company is able to manage the growth.
Too little can be as much a concern to the
bank as too much growth.
Times
interest covered
Net
Profit before Interest and Tax = Interest
Cover Ratio
Total Interest Expense
As
previously stated, the interest cover ratio
gives an indication of how profitable the
company is in relation to its interest cost.
To low a ratio suggests to the banks that
the business has too much debt and/or that
debt servicing may be under pressure.
Return
on Tangible Assets
Net
Profit
Total Tangible Assets
This
gives the business owner an idea of what his/her
return is on the value of assets being employed.
It begs the question "is the yield sufficient
for the assets employed?"
Return
on effective capital
Net
Profit
Effective Capital
EC
= (Paid up capital, reserves, retained earnings
and shareholders' advances less intangibles
ie goodwill, prepayments etc, commonly known
as shareholders funds)
This gives the business owner an idea of what
his/her return is on the value of the capital
the owner has at risk in the business. It
also begs the question "is the yield
sufficient for the assets at risk?"
Solvency
Ratios
Current
Ratio
Current
Assets
Current Liabilities
This
compares current assets to current liabilities
and is used to establish a working capital
position. A ratio of less than one suggests
a working capital deficit that will usually
evidence itself by high overdraft usage, excesses
and slow payment of creditors.
The
quick ratio
Cash
+ Stock + Trade Debtors
Current Liabilities
The
quick ratio provides a view of a business's
ability to satisfy its current obligations
from assets that are either cash or easily
converted to cash like stock.
Gearing
Ratio
Total
Liabilities
Effective Capital
(Effective
capital is total shareholders' funds less
intangibles ie goodwill, prepayments etc)
This
shows how much the owners/shareholders have
invested in their business. Banks like to
have less invested in the business than the
owners.
Adjusted
Gearing Ratio
Total Liabilities - Non-Current Subordinated
Debt
Effective Capital+ Non-Current Subordinated
Debt
Note:
Subordinated debt is debt the company has
from its shareholders or other parties that
the banks have placed below their lending
to the company. Non-current means it is not
due in the next 12 months.
This
restates the relationship between debt and
equity to allow for shareholders loans to
the company. The banks recognise this as quasi
equity. Generally the banks will seek a "Deed
of Postponement" to place greater reliance
on these loans as committed equity.
The
greater the portion of debt relative to the
owner's equity, the greater the risk to the
bank's lending.
Efficiency
Ratios
Working
Capital
Working
Capital = Current Assets - Current Liabilities
If
current assets exceed current liabilities,
the business has a working capital surplus;
if it is negative then the reverse is true.
It
is very important this is understood and well
managed. Working capital is the liquidity
that keeps the business trading.
Stock
turnover rate
Cost
of Goods Sold
(Opening Stock + Closing Stock)/2
This
provides how many times the stock turns over
each year. Supermarket stock would and should
turn over almost daily but a jeweller's stock
would turn over much more slowly.
Debtor
Days outstanding
Trade
Debtors x 365
Sales (last 12 months)
This
ratio shows how many days it takes on average
to collect debtors. The fewer the days the
better the cashflow into the business.
Creditor Days outstanding
Trade
Creditors x 365
Sales (last 12 months)
This
ratio shows how many days it takes on average
to pay creditors. The fewer the days the quicker
the payments are made to creditors. It is
important to the bank that arranged terms
with creditors are being respected. Early
payment can also mean the opportunity for
the business to gain discounts.
Gross
Profit to Sales
Gross
Profit x 100
Sales (last 12 months)
Gross
profit ratio is used to show the gross margin
being obtained from sales and the business
should use this to compare to its budgeted
result.
Net
Profit to Sales
Net
Profit x 100
Sales (last 12 months)
Net
profit ratio is used to show the net margin
being obtained from sales. The net profit
can be manipulated considerably and this needs
to be understood for comparison to have any
meaning.
Trends
The
bank will have your other years' results on
file and will compare the above ratios on
a year on year basis, thereby providing an
insight into the trends for each. They will
ask themselves whether the ratios are improving?
Are the margins being maintained? Are the
trends highlighting any adverse trends that
need to be taken up with the management?
This
was not meant to be an accounting lesson,
but merely a guide to what the banks will
be looking at in your annual accounts. By
understanding this you can better manage your
own business and better manage your relationship
with your bank.
