Some of the challenges a business can face in its financial management include inadequate liquidity, under-capitalization, under or sub-utilization of assets, past due or delinquent accounts receivable, insufficient sales, excessive expenses, and the resulting insufficient profitability. There are financial analysis techniques that can be used to identify these problems and determine the actions that need to be taken to overcome them and improve the overall financial performance of the business.
A business needs liquidity in order to meet its commitments and to take advantage of opportunities for growth and development. Liquidity means having sufficient cash and current assets readily convertible into cash in order to pay current liabilities as they become due for payment.
Current assets that can be converted into cash include marketable securities, trade accounts receivable, and inventory. Timing is an inherent aspect of liquidity, and while these items are all included in current assets and therefore enter into working capital analyses and comparisons, their liquidity will depend on the particular circumstances of the business.
Trade accounts receivable, for example, are liquid to the extent they can be collected. And the timing with which they are converted to cash depends on the credit terms granted to customers, such as 30, 60, or 90 day payment terms.
Inventory is liquid according to how often inventory is turned over, or sold. Inventory that is sold quickly, on cash terms, is more liquid than inventory that remains on hand for extended periods of time, and is sold on credit terms. The nature of the business also affects the liquidity of inventory. A business with an inventory consisting of a large variety of lower-priced items may be able to generate a more consistent cash flow from sales than a business with a relatively small number of higher-priced goods that do not have a rapid turnover.
Ã?Â· Current ratio, which is current assets divided by current liabilities. The higher the ratio, the greater the liquidity. A ratio of 1.0 means there are just enough current assets to cover current liabilities – a break-even liquidity situation. A ratio of less than 1.0 means there are liquidity problems.
Ã?Â· Acid-test ratio, which is cash plus realizable assets (current assets less inventory) divided by current liabilities. This is a more stringent measure of liquidity.
Ã?Â· Cash ratio – balance of cash on hand and in banks divided by current liabilities. This would indicate how much of current liabilities could be covered by the cash available today.
Ã?Â· Ratios of working capital, as compared to total assets, short-term debt, and sales, can also be liquidity indicators. And, if these ratios are calculated at different points in time, a dynamic analysis can be performed, showing the trends that liquidity is taking.
Ã?Â· An analysis of the type of financing that the business is using, showing the terms and conditions of debt, such as how much is current and how much is long-term, and the corresponding interest rates, will show the quality of the debt the business is carrying.
Ã?Â· Cash flow report, comparing actual results to forecast results, identifying where liquidity problems are originating and where there may be opportunities to improve liquidity.
Improvement Measures to Take
Ã?Â· Increase capital. Capital contributed in the form of cash will increase liquidity immediately. And, equity financing reduces the need for debt financing.
Ã?Â· Refinance debt with better terms and conditions.
Ã?Â· Leasebacks may be an alternative to capital expenditures for fixed asset purchases.
Ã?Â· Sales of fixed assets or other property. The decision to sell assets will need to be weighed against the income-generating capacity of those assets.
Ã?Â· Shorten the maturity cycle – the time from purchases of raw materials and the start of production, or the start of the income-producing activity, until collection on accounts receivable.
Ã?Â· Negotiate longer payment terms with vendors or other creditors.
Under-capitalization basically means that there is not enough capital invested, and the business is relying more heavily on debt financing or self-financing from business operations – generating profits and reinvesting the profits in the business. Heavy reliance on debt financing can potentially result in an eventual solvency problem, especially during period of a business or economic downturn.
A business that relies on the results of its operations to finance investment in the business will do well as long as the business is profitable and growing. But this may not provide a sufficient reserve for any contingencies that could arise, and may not be sufficient to make major investments in fixed assets, research and development, and expansion.
Ã?Â· Ratio of debt to total liabilities and equity. The higher the ratio, the more under-capitalized the business.
Ã?Â· Ratio of owner’s equity to total debt. A higher ratio in this case shows a greater level of capitalization.
Ã?Â· Ratio of assets to debts. The lower the ratio, the more indebted the business. A ratio of 1.0 would show that the business has just enough assets to cover its debts.
Ã?Â· Interest and other debt servicing costs as a percentage of net income before interest and taxes. The higher the percentage, the more of a business’s earnings are going toward paying for debt-related costs.
Ã?Â· Ratio of net cash flow to total loans shows the percentage of the cash being generated by the business that is going toward paying down loans.
Ã?Â· Ratio of interest and other debt servicing costs to total debt shows the effective percentage cost of debt, or the effective overall interest rate.
Ã?Â· Ratio of interest expense and dividends to total liabilities and capital, which represents the total percentage cost of debt and equity financing.
Ã?Â· Ratio of interest expense to total sales, which shows how much of sales income is going toward debt-servicing costs.
Ã?Â· Analysis of loans, showing the types of loans and their respective terms and conditions. As in the case with liquidity measures, this shows the quality of the debt the business is carrying.
Improvement Measures to Take
Ã?Â· Increase capital. This will depend on the type of business structure. In a sole proprietorship it means making additional capital contributions. In a partnership, additional capital contributions would have to be requested from the partners. And in a corporation, additional shares would need to be issued. For a closely-held corporation, it may mean going public.
Ã?Â· Re-finance debt at lower interest rates.
Ã?Â· Obtain new loans, possibly long-term loans at lower interest rates, to pay off short-term debt with a higher interest rate.
Ã?Â· Use mortgage debt, at a lower interest rate, to pay off unsecured loans, at higher rates.
Ã?Â· Request extensions of payment terms.
Ã?Â· Sell off assets in order to pay down debts.
Under-Utilization of Assets
Assets are under-utilized if they are not being used to their full potential or up to their capacity. This creates an inherent cost, because the investment in those assets is not yielding as much as intended, and the investment cost is essentially locked up and not available for generating additional revenue and profits.
Ã?Â· Ratios of sales to total assets, fixed assets, or current assets. These ratios show how much revenue assets are generating. The higher the ratios the better assets are being utilized.
Ã?Â· The collection period, in terms of number of days, shows how quickly assets are being used to generate and collect revenue. The shorter the collection period the more efficiently assets are being utilized.
Ã?Â· Inventory rotation period, which shows how quickly inventory is being turned over to generate revenue. The shorter the period, the more efficient the operation.
Ã?Â· Ratio of trade accounts receivable to trade accounts payable. This shows how well a business is using credit terms with its vendors to finance its own operation.
Ã?Â· Ratio of accumulated depreciation and amortization to annual depreciation and amortization. A lower ratio means that assets are depreciating or becoming obsolete quickly, while a higher ratio means that assets have longer depreciable or amortizable lives, and are presumably contributing to the generation of revenue for longer periods.
Improvement Measures to Take
Ã?Â· Implement and use total quality assurance practices and procedures throughout the entire business cycle.
Ã?Â· Reduce the maturity cycle – the time from the initial purchase of raw materials and supplies for production through final collection on account from customers.
Ã?Â· Increase the rotation of inventory by discounting slow-moving items, and selling off obsolete items.
Ã?Â· Use just-in-time delivery methods to reduce the investment in inventory on hand.
Ã?Â· Subcontract or outsource certain phases of the productive cycle that can be more efficiently performed outside the business.
Ã?Â· Implement and carry out preventive maintenance and scheduled maintenance of plant, machinery and equipment.
Ã?Â· Follow design capacity indications for plant, machinery and equipment.
Ã?Â· Replace obsolete or inefficient machinery, and equipment.
Past Due or Delinquent Accounts Receivable
Controlling past due or delinquent trade account receivable involves the whole credit cycle, from the decision to grant credit to a customer or client through final collection on an outstanding invoice.
Ã?Â· Accounts receivable aging report. This report shows each customer’s account, broken down by invoice date and due date for payment. Accounts that are slipping into the 30 and 60 days past due columns need attention. Accounts more than 90 days overdue are in jeopardy of being lost.
Ã?Â· Average collection period in terms of number of days to collect.
Ã?Â· Unpaid invoices as a percentage of sales. The higher the percentage the more money is tied up in receivables.
Ã?Â· Uncollectible accounts as a percentage of sales. This is the percentage of sales that turn out to be bad debt expense.
Improvement Measures to Take
Ã?Â· Manage credit. Review the decision-making process for granting credit to potential customers and clients, including required information and references, and the selection criteria used. Implement and follow procedures for regular issuance of statements of account and follow-up collection calls.
Ã?Â· Offer discounts for prompt payment, for example 1% discount for payment within 10 days of invoice date.
Ã?Â· Take out a credit insurance policy.
Ã?Â· Factor accounts receivable.
Insufficient Sales, Excessive Expenses and Insufficient Profitability
Sales revenue must be sufficient to cover costs and expenses, and generate a profit. Insufficient sales revenue may be due to pricing factors, volume factors, or both. Expenses in all aspects of the business must be clearly identified, tracked, and controlled. And profitability should be analyzed by business unit, by product or service, by geographical area, and according to any other relevant criteria.
Ã?Â· Sales in the current period as compared to sales for the previous period. This shows the rate of sales growth.
Ã?Â· Market share.
Ã?Â· Price and volume variance analysis.
Ã?Â· Price increases as compared to inflation.
Ã?Â· Sales of new products as a percentage of total sales.
Ã?Â· Actual sales compared to forecast sales.
Ã?Â· Ratio of each type of expense to total sales. A dynamic comparison at different points in time will show tendencies.
Ã?Â· Comparison of an expense in the current period to the same expense in the previous period.
Ã?Â· Sales revenue divided by the number of employees. This shows how much each employee is contributing to overall revenue.
Hours lost as a percentage of total hours. This could be a production or other type of indicator.
Ã?Â· Actual production compared to production capacity. This is an efficiency indicator.
Ã?Â· Unit production cost.
Ã?Â· Added value analysis – how much is each cost contributing to the value of the end product.
Ã?Â· Net income as a percentage of owner’s equity. This is a return on investment ratio.
Improvement Measures to Take
Ã?Â· Implement or revise a marketing plan, invest in appropriate advertising and publicity for the targeted consumers, expand consumer knowledge of your product or service, offer new or improved products based on customer needs.
Ã?Â· Use total quality control systems to eliminate defects and improve efficiencies throughout the business.
Ã?Â· Increase productivity by properly training personnel, using machinery and equipment in accordance with their design capacity and specifications, outsource work that can be done more cost-efficiently outside the business.
Ã?Â· Develop realistic budgets and compare actual results to budget.
Ã?Â· Improve employee motivation by creating and maintaining a healthy work environment and providing appropriate incentives.
Ã?Â· Invest in the necessary information systems to adequately handle the flow of information and transactions in the business, as efficiently as possible.
Ã?Â· Be aware of the tax consequences of business transactions.