Financial Tools and the Legal Environment

 

 

 

Week 2 Financial Ratios & Breakeven Analysis

 

§ Describe how financial ratios are used to monitor a venture’s performance

 

§ Apply ratios in different ratio categories and explain how they are calculated and used by an entrepreneur, by lenders and creditors or equity investors

§ Describe limitations when using financial ratios

 

§ Analyse breakeven sales

Financial Ratios

§ show the relationship between two or more financial variables.

§ help simply comparisons of a venture’s performance with itself and other firms over time.

Why do entrepreneurs need to understand financial ratios?

§ It allows the entrepreneur to assess the soundness of a company’s activities as well as identify important trends.

§ Many banks provide business loans on the condition that the company maintains certain minimum ratios, such as debt/equity.

§ Venture capitalists, may use ratio attainment as “milestones” for determining whether and when they will invest more capital.

4

 

Trend Analysis

§  Examination of a venture’s performance over time

§  Example: a comparison of net profit margin across a 3-year or 5-year period. Is the business’s internal performance better today than 3-years or 5-years or ago? Why?

Cross-sectional Analysis

§  Comparison of a venture’s performance against another firm at the same point in time

§  Assessment of the company’s operations, financial condition, and activities against comparable companies.

Industry Comparable Analysis

§  Comparison of a venture’s performance against the average performance in the same industry              5

 

 

Liquidity Ratio

 

Current ratio:

 

$1,190/$2,100 = 0.57

 

Quick ratio (Acid-test ratio):

 

$(1,190 – 600)/$2,100 = 0.28

 

Excluding only inventory from current assets when calculating quick ratio

•          This approach puts an emphasis on analysing whether a company’s current assets are highly dependent on inventory,

i.e. quick ratio is much lower than the current ratio.

•          Some current assets, e.g. prepayments and advances to suppliers that cannot be used to cover current liabilities should also be excluded. Nevertheless, a company may merge prepayments with accrued income, e.g. Sainsbury’s, but another may not, e.g. M&S. To avoid inconsistency in a cross-sectional analysis, we focus on analysing whether current assets depend on inventory by excluding only inventory from current assets in the quick ratio.

6

	A modification to D/E ratio into LTD to equity       •          An approach that helps analysts to focus on important risks, i.e. LTD. •         The ratio is used as a measure to gauge how a company finances its operations through debt versus equity. For small businesses, LTD is a key source of financing operations. Using LTD provides a measure that focuses on this key financing source, e.g. would Bruce rely on accounts payable, wage payable to finance its operations?
	Debt/equity Ratio
	Long-term debt (LTD) to equity $9,000/$5,590 = 1.61 or 161%

 

§ Some of the most important assets (knowledge, experience, creativity, and

existing business relationships) are not recorded.

§ Industry comparisons can be misleading for several reasons.

o       A smaller, rapidly growing venture might benefit from comparing to other young ventures in the same or a related industry, rather than industry averages representative of mature firms.

o       Ratios are calculated the same way for the venture and its comparable firms.

o       Seasonal factors can distort ratio comparisons. It is important to make comparisons at the same point in time and with the same fiscal year.

 

o       Avoid looking at only on or two ratios – view a full set of ratios                                                            20

Breakeven Point

Successful entrepreneurs know how many units of their products or hours of service they have to sell or provide, respectively, before they can take any real cash out of the company.

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21

Fixed expenses

Fixed expenses or cots are expected to remain constant over a range of revenues for a specific time period, such as a year.

 

§  General and administrative expenses, including predetermined compensation in the form of base salaries.

§  Marketing expenditures to acquire customers, e.g. a business plan may require advertising costs to be fixed, i.e. a business contractual commitment over a year.

§  Rental payments

§  Insurance premiums

 

 

 

22

Variable expenses

Variable expenses or cots are expected to change in proportion to production output or use of services.

§  Cost of goods sold (COGS), i.e. direct labour costs and cost of raw materials

§  Sales commissions

 

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