ENHANCE FINANCIAL REPORTING SYSTEM WITH FINANCIAL RATIOS

Many Small and Medium Enterprise (SME) owners in Malaysia are facing constraints as they lack reliable and relevant information to manage their business. Their accounts personnel may or may not submit monthly financial statement such as balance sheet and income statement to the owner. Without further analysis and interpretation of these financial data, useful information of these data cannot be furnished to owner to plan and control their business.

From our experience, there is huge advantage for owners who plan their business that is assisted with monthly financial statement and ratio analysis. These owners are much more sensitive to their business's performance compared with those who manage their business without using financial analysis and information.

The following financial ratio and analysis are recommended to be included into every business's monthly/quarterly financial reporting system.

Name
Formula
Description
Current ratio Current Assets
———————
Current Liabilities
The current ratio can be interpreted as the ability of a company to pay its short-term creditors from the realisation of its current assets.

Ideally the figure should be 2:1 or always be greater than 1. The ratio signifies that there are sufficient assets available to pay liabilities, should the need arise. Therefore the higher the figure the better.

Financial ratios may differ in different industries. For example for industries such as transport where the majority of assets are tangible fixed assets, then a figure of 0.6 would be acceptable. In retail and manufacturing we would expect figures between 1.1 to 1.6; in wholesale and construction 1.1 to 1.5 and motor vehicles 1.2 to 1.6.

Liquidity ratio Liquid Assets ———————
Current Liabilities

Liquid Assets = Current Assets - Stock
The liquidity ratio is commonly viewed as a more accurate assessment of a company's financial health than the current ratio as it excludes stock.

A liquidity ratio is 1:1 for example is considered satisfactory.

Figures of this ratio are lower than the current ratio. For example, clothing retailers operate at very low levels, with average figures being between 0.2 and 0.6 and retail as a whole between 0.3 and 0.7 as cash are received very quickly for goods sold. For supermarkets ratios as low as 0.4 may be acceptable with cash being received for goods sold, before the goods are actually paid for. In manufacturing figures between 0.7 and 1.1 are seen as acceptable and for wholesalers 0.7 to 1.0. In the construction industry, companies should operate at between 0.6 and 1.0.

Name Formula Description
Receivable turnover Credit Sales
= ———————
Receivables

365
= ———————
Receivable turnover
This receivables ratio measures the length of time a company takes to collect its debts and how well accounts receivables are being collected; it is measured in days.

Normal payment terms are at the end of the month following delivery, giving an average credit of between 30-60 days. In the clothing retailers industry, some companies show some of the lowest figures with averages of around 7 days. In manufacturing average figures are around 63 days, with 42 being experienced at the top end and 84 days at the lower end. Average for wholesalers is around 56 days, whilst in construction the figures are lower, at around 45 days.

Some companies may face excessively slow collection of more than 120 days and this could severely affect the liquidity of the company.

Payables turnover Credit Purchases
= ———————
Payables

365
= ———————
Payables turnover
The payables turnover measures the length of time it takes a company to pay its creditors, it is measured in days.

Generally the average figure is around 30 days. In the manufacturing sector, it normally takes around 37 days for companies to pay its creditors. For wholesalers the average rises to 37 days, with top and bottom figures being 18 and 61 days respectively. For the retail industry the average figure is 23. For food retailers the norm is as low as 8 - 12 days.

Inventory turnover Cost of Goods Sold
= ———————
Inventory

365
= ———————
Inventory turnover
This inventory ratio shows how well a company manages its inventories and it is measured by the number of times a company converts its stock into sales.

For example, a reasonable inventory turnover for manufacturing company is around 25 - 30, decreasing with the larger and more complex the goods being made. For retail and wholesale, average figures would be lower at around 9 - 10. For construction, average stock/turnover figures would be around 16.

Name Formula Description
Gross profit margin


Net profit margin
Gross profit
= ———————
Turnover

Net profit
= ———————
Turnover
The gross profit margin of measures the profitability on sales throughout the year. This is the main indicator when measuring the efficiency of the operation, and it measures the percentage of sales dollar remaining to cover fixed cost of the company.

For example for manufacturing industry, an average of between 6% and 8% is considered the norm. For high volume/low margin activities like food retailing can run very satisfactorily at around 3%. Retailers generally will have a lower profit margin than most industries. Highest margins of all are usually experienced in service industries where margins above 10% are enjoyed. There are some specialised industry who operates with margins of above 20%.

Return on equity Net Income
———————
Shareholders' equity
The Return on Equity of a company measures the ability of the management of the company to generate adequate returns for the capital invested. This is the most important ratio for business owners. Generally a return of 10% would be desirable to provide dividends to owners and have funds for future growth of the company. If the return is lower than the rate of alternative investments such as bank savings, it is more advisable for owners of these businesses to invest their money elsewhere.

This ratio is more meaningful to the equity shareholders who are interested to know profits earned by the company and those profits which can be made available to pay dividends to them.

The financial statement and mentioned ratio analysis are only to show it's supremacy on business management when it's interpreted by experienced and qualified accountant. Many SME companies are lacking budget to hire a qualified accountant to lead the finance department. They can get assistance from public accountant firm or advisory company on monthly/ quarterly basis to align their financial strategic based on ratio analysis.

At YYC Advisors, we assist our clients to interpret and most importantly on measures that can be taken to improve their financial performance. For further information, kindly Contact Us