Cost Of Goods Sold vs Gross Revenue : Any business that wants to grow and scale needs financial stability. The financial health of every company is the most critical factor in determining the potential to scale. Any company struggling to meet its day-to-day expenses can’t hope to become one of the top 100 Fortune companies.
Investors, bankers, and creditors will only take a risk on your business if you have the ability to learn and run. Poor financial metrics, negative operating balances, and negative cash flows are the biggest signs of incompetency for any business.
What can be done to bring your business entity on the right track?
Increasing revenue and decreasing expenses can be used to improve the performance of your business and better its financial health. This can be accomplished through more action and better capitalizing on more profitable opportunities.
But I still have a question: How can you know about your company’s financial health? It’s not just about your net profit or how much cash you have in your pocket.
The ratio analysis is the most useful financial analysis used in financial management. It enables business to learn the financial health of the business by comparing it with previous years.
Besides, various financial aspects of the company are reviewed from a historical and comparative perspective. Thus, we can say that ratio analysis gives a blueprint of the business’ weakness and strength.
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Ratio Analysis In Financial Management
The ratio analysis provides an important tool for analyzing a company’s financial health and its market position. Investors and creditors can use ratio analysis for comparing companies.
There are 5 key elements that constitute a complete ratio analysis that considers an entity’s financial health. They are as follows:
Revenues of a company
It includes metrics relating to revenue growth, revenue per employee, and other metrics related to revenue.
A firm’s profitability is very important to its future prospects. In order to analyze the future prospects of any business entity, it must demonstrate consistently growing profits. Gross profit, net profit, and operating profits are a number of the metrics to analyze profitability.
The most common operational efficiency measures are inventory turnover ratios, asset turnovers, receivable turnovers etc. Successful businesses display maximum efficiency with the limited resources available.
Capital Efficiency and Solvency
Debt to equity ratio, return on equity as well as other metrics provide an indication of capital efficiency and solvency. A business must exist in the long term. The capital efficiency or solvency of a company is determined through the ability to pay off debt.
The fifth area of thorough financial analysis is liquidity. Liquidity measures the company’s ability to cover current obligations and debt. Short-term items refer to the upcoming year, while coverage ratios refer to ratios that cover existing liabilities not carried forward from previous years.
Expenditure Coverage Ratios
Capital expenses and operating expenses are two types of expenses.
Capital expenses are the costs of financing and investing activities of a business. They are usually spread over several years.
An operating expense is usually a recurring expenditure for the current financial year. This is usually a cost incurred for running a business on a day-to-day basis.
An expenditure coverage ratio is the best measure of assessing a company’s ability to pay its expenditures. Due to the fact that coverage ratios are based on capital expenditures, they are different than expenditure coverage ratios.
The expenditure coverage ratios includes both operating and capital expenditures. Therefore, they go beyond just coverage ratios.
We can define expenditure coverage ratios as,
Types Of Expenditure Coverage Ratios
The following ratios have been identified based on the definition under the category of spending coverage ratios.
- Coverage Ratios
- Liquidity Ratios
The coverage ratio of a company evaluates its ability to pay off its debt, specifically the ability to pay back its liabilities. It measures how well the company’s assets can pay off its obligations or expenditures. The minimum coverage ratio standard is 1:1.
Following are some of the coverage ratios:
Interest Coverage Ratio
The interest coverage ratio is a calculation that assesses the capacity of an organization to pay interest on its debt. This ratio does not take into account the ability of the company to repay the debt itself.
The ratio of interest to income (interest coverage ratio) must be a minimum of 1:1. If it is higher than that, for example, a ratio of 2:1, this indicates a healthier financial position.
The formula for interest coverage ratio is as follow:
Interest Coverage Ratio= Operating Income / Interest Expense
Debt-Service Coverage Ratio
The debt service coverage ratio indicates whether a company can meet its debt obligations by using operating income. The debt obligations include principal and interest expenses. This ratio is most commonly calculated when applying for a bank loan.
The minimum standard for DSCR is also 1:1, but a higher ratio of 2:1 or above is better.
The formula for debt-service coverage ratio is as follow:
Debt-Service Coverage Ratio= Operating Income / Debt Service
Asset Coverage Ratio
The asset coverage ratio determines whether assets can cover debt obligations. It measures a company’s ability to cover debt obligations through the sale of assets after settling liabilities. The asset coverage ratio is not included in the expenditure coverage ratio. However, it does not influence the capital expenditure coverage ratio.
Asset Coverage Ratio = (Total Assets – Intangible Assets) – (Current Liabilities – Short-term Debt)/Total Debt Obligation
Cash Coverage Ratio
This coverage ratio assesses the capacity of a company to cover its interest payments. Basically, it relates to how well it can utilize its own cash to pay its annual interest payments.
The ratio of 1:1 or above is considered the better measure.
The formula for cash coverage ratio is:
Cash Coverage Ratio= Total Cash / Interest Expense
These liquidity ratios help companies understand how much current assets it will need to meet its short-term obligations and current liabilities based on available current assets and cash. Liquidity ratios belong to operating expenditure coverage ratios.
This ratio measures how well the company’s cash equivalents can pay its current liabilities. This includes short-term debt, account payables, outstanding expenses, outstanding taxes & insurances, and outstanding obligations.
Following liquidity ratios come under the scope of expenditure-coverage ratios :
The current ratio measures the company’s ability to cover the short-term financial obligations by using current assets. The ratio of 1:100 is the standard. A higher ratio signals the company’s ability to meet its obligations more efficiently.
In any case, too much high ratios are an indication of a company’s capital being narrowed and thereby limiting profit-making abilities.
The formula for the current ratio is as follow:
Current Ratio= Current Assets / Current Liabilities
An individual’s ability to meet short-term obligations can be more precisely assessed using the quick ratio than using the non-current asset ratio.
This is because these items may take some time to be converted into cash. Therefore, including them would inflate the company’s ability to meet its obligations on time.
Quick Ratio= Cash + Account Receivables + Marketable Securities / Current Liabilities
The cash ratio measures how well a company can meet its short-term obligations by using cash and cash equivalents. The ratio must be greater than 1:1. These accounts receivable are also deducted from the equation. Because these funds might also take time to settle.
Quick Ratio= Cash + Marketable Securities / Current Liabilities
Why Does Expenditure Coverage Ratios Matter?
Why does the expenditure coverage ratios of a company are important?
These ratios are most widely used by the external as well as internal stakeholders of any business.
With regards to internal stakeholders, expenditure coverage ratios allow companies to assess how well they’ll be able to cover their long-term and short-term expenses. By assessing the results, companies will be able to determine whether or not to invest in new opportunities.
If the quick ratio of the enterprise is 4:1, it indicates the enterprise has a lot of excess cash and equivalent. This is affecting its operating efficiency negatively. Therefore, the enterprise must use excess cash for investment to make use of capital.
For external stakeholders, coverage ratios are deployed the most. These coverage ratios help investors and creditors decide about the investment’s attractiveness. An investment that includes a good coverage ratio shows good creditworthiness. It also ensures the investors and creditors that an investment is secure.
Internal and external stakeholders utilize both expenditure coverage ratios in order to assess the company’s attractiveness from a debt-issuing and investment prospectus. Also read Corporation Advantages and Disadvantages