Understanding Basic Financial Ratios for Informed Business Decisions

By Chris Emoghene | 5 min read
24th October 2018
Understanding Basic Financial Ratios for Informed Business Decisions

Let me share a short story with you. I recall being with the managing partner of a top real estate firm in Delta State when his phone rang. For the sake of this story, I will refer to as Mr. Ovie. The caller, a real estate agent, was offering him a 12-flat apartment of 2-bedroom each at N70 million, which according to the agent was a giveaway price. Where is it located? Asked Mr. Ovie. It is located at Udu, replied the real estate agent. After a brief pause, Mr. Ovie told the agent 'I won't buy, it is not a good deal. I would rather buy a 4-bedroom duplex at Bendel Estate for N30 million than putting N70 million on that property.' Thereafter, they exchanged pleasantries and that was it.

Mr. Ovie did not have any difficulty in turning down a seemingly great proposal which a novice would have jumped at without crunching the numbers, only to realize his folly way too late. Mr. Ovie did a mental calculation! Now let's look at why he turned down the offer, using: first, simple ratio analysis; and then, other considerations.

For the property at Udu (A), let's consider its best case scenario as a rental property: annual rent of N250,000 per flat.Therefore, yearly rentals will be 12 flats X N250,000 (assuming every flat is occupied) = N3,000,000.00. Therefore, time it will take to recoup initial investment using today's value is 70million/3million = 23.3 years

While for the 4-bedroom duplex in Bendel Estate (B), we will apply the worst case scenario.

As a rental property: annual rent is N1,500,000. Therefore, the time it will take to recoup initial investment using today's value is 30million/1.5million = 20 years

From the figures above, it is very obvious why Mr. Ovie turned down the proposal. When stretched even further, say one invested in two 4-bedroom duplexes at Bendel Estate, with N60 million one will get same annual return (worse case) as N70 million invested in Udu (best case). This is without considering annual maintenance cost, having to worry about so many tenants, and security concern, which are of course higher for the investment in Udu.

By understanding his numbers and ratios, Mr. Ovie was able to save his company and himself a lot of stress.

In the same vein, every MSME operator/entrepreneur needs a fair knowledge of some basic financial ratios for sound decision making for business success. These ratios will among other things help you to assess the profitability, liquidity, leverage and efficiency of a part or the whole business. I will attempt to discuss some of the basic ratios and their application in business decision making in subsequent paragraphs.

PROFITABILITY RATIOS: Since every MSME is profit oriented, it is important to determine the profitability or otherwise of any investment using projected figures before venturing into it or review the profitability using historical figures, for an existing investment, to decide whether or not to continue with the investment. This is critical to the long-term success and scalability of the business. Some of the ratios that will help determine the profitability of an investment include:

  • Gross Profit Margin (GPM): This shows how much profit a business makes after settling its Cost of Goods Sold. It is often expressed as a percentage of sales. GPM = Gross profit/Net sales*100. The higher the profit margin, the more efficient the company is.
  • Net Profit Margin (NPM): This is calculated by dividing net profit (that is, gross profit minus other expenses incurred by the business within the period under review) by total sales. It is also expressed as a percentage. NPM = Net profit/total sales*100. It is a measure of how much of each Naira generated by the company translates into profit. Again, the higher the margin, the more efficient the company is.
  • Return on Equity (ROE): This shows how much a business makes from each Naira the owners or shareholders put into it. It is calculated by dividing net income by owners' equity. ROE = Net income/shareholders' equity. If you have two or more projects competing for your Naira, the one with the highest ROE should be chosen over the others.

LIQUIDITY RATIOS: These ratios measure the ability of a business to meet its current obligations as they fall due. Every MSME like any other company needs some level of cash or cash equivalents to settle its immediate expenses in a timely manner. Liquidity ratios can be a pointer to when a business need additional capital or debt funding. It can also provide information to regulate account receivables and negotiate or renegotiate account payables. Some of the liquidity ratios include:

  • Current Ratio: This is a measure of the number of times a business' current assets can cover its current liabilities as at the Balance Sheet date. Current Ratio = Current Assets/Current liabilities. A ratio of 1:1 means the business just have enough current assets to cover its current liabilities. This might not be good enough, though, depending on the industry. A higher ratio, say 2:1, is usually desirable.
  • Quick Ratio (Acid Test): This is a stricter version of current ratio, in the sense that it only recognizes cash and assets (such marketable securities and receivables) that can be easily converted to cash in its computation. Inventories are excluded in this case. A quick ratio of 1:1 is considered the best. If the quick ratio is higher, it implies the business is either keeping too much investible funds or it has a poor account receivable collection drive. On the other hand, if it is lower, it may mean that the business will not be able to settle its immediate liabilities quickly.

LEVERAGE RATIOS: Leverage ratios are measures of the degree of indebtedness of a business and the level of risk associated with it. An example of leverage ratio is debt ratio.

  • Debt Ratio: This ratio measures the portion of the business' total assets that is financed by debt. That is, Debt Ratio = Debt/Total Assets. A business with a debt ratio of more than 1.0 is highly leveraged. It means the business has a negative networth. It may also indicate that the business has a low borrowing capacity, as this is usually checked by the banks.

EFFICIENCY RATIOS: Efficiency ratios measure how well a business manages its assets and liabilities to generate income. Some of the efficiency ratios include Inventory Turnover, Accounts Receivable Turnover (which measures how fast a business collects its credit sales), Accounts Payable Turnover (which measures how fast a business pays its creditors), etc. A high Account Receivable Turnover is desirable while the opposite is true for Accounts Payable Turnover.

Generally, understanding some basic financial ratios will help you:

  • Make quick and sound business decisions.
  • Better manage your scarce resources.
  • Grow your business and increase profitability
  • In planning and budgeting, among others.

Therefore, I recommend further study on the basic financial ratios to startups, entrepreneurs and business managers.

Chris Emoghene
Chris Emoghene has over eleven (11) years banking experience across public sector, retail and commercial banking. He is skilled in Business Development, Loan Structuring and Monitoring, Negotiation, Budgeting, Analytical Skills, Risk Management, Customer Service, and Relationship Management. He is an open-minded and an energetic person who is always willing to learn and take up new challenges. He is a member of the Financial Inclusion State Steering Committee (FISSCO) that was inaugurated on January 11, 2018. Chris has special interests in writing and entrepreneurship.
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