The 30 Day MBA by Colin Barrow Page A

financial ratios are meaningful in themselves, but their value mainly lies in their comparison with the equivalent ratio last year, a target ratio, or a competitor’s ratio.
    Before we can measure and analyse anything about a business’s accounts we need some idea of what level or type of performance a business wants to achieve. All businesses have three fundamental objectives in common, which allow us to see how well (or otherwise) they are doing.
    Making a satisfactory return on investment
    The first of these objectives is to make a satisfactory return (profit) on the money invested in the business.
    It is hard to think of a sound argument against this aim. To be satisfactory the return must meet four criteria:
It must give a fair return to shareholders, bearing in mind the risk they are taking. If the venture is highly speculative and the profits are less than bank interest rates, your shareholders (yourself included) will not be happy.
You must make enough profit to allow the company to grow. If a business wants to expand sales it will need more working capital and eventually more space or equipment. The safest and surest source of new money for this is internally generated profits, retained in the business: reserves. (A business has three sources of new money: share capital or the owner’s money; loan capital, put up by banks etc; retained profits, generated by the business.)
The return must be good enough to attract new investors or lenders. If investors can get a greater return on their money in some other comparable business, then that is where they will put it.
The return must provide enough reserves to keep the real capital intact. This means that you must recognize the impact inflation has on the business. A business retaining enough profits each year to meet a 3 per cent growth is actually contracting by 1 per cent if inflation is running at 4 per cent.
    Maintaining a sound financial position
    As well as making a satisfactory return, investors, creditors and employees expect the business to be protected from unnecessary risks. Clearly, all businesses are exposed to market risks: competitors, new products and price changes are all part of a healthy commercial environment. The sorts of unnecessary risk that investors and lenders are particularly concerned about are high financial risks, such as overtrading.
    Cash-flow problems are not the only threat to a business’s financial position. Heavy borrowing can bring a big interest burden to a small business, especially when interest rates rise unexpectedly. This may be acceptable when sales and profits are good; however, when times are bad, bankers, unlike shareholders, cannot be asked to tighten their belts – they expect to be paid all the time. So the position audit is not just about profitability, but about survival capabilities and the practice of sound financial disciplines.
    Achieving growth
    Making profit and surviving are insufficient achievements in themselves to satisfy either shareholders or directors or ambitious MBAs – they want the business to grow too. But they do not just want the number of people they employ to get larger, or the sales turnover to rise, however nice they may be. They want the firm to become more efficient, to gain economies of scale and to improve the quality of profits.
    Accounting ratios
    Ratios used in analysing company accounts are clustered under five headings and are usually referred to as ‘tests’:
tests of profitability;
tests of liquidity;
tests of solvency;
tests of growth;
market tests.
    The profit and loss account and balance sheet in Tables 1.7 and 1.8 will be used, where possible, to illustrate these ratios.
    Tests of profitability
    There are six ratios used to measure profit performance. The first four profit ratios are arrived at using only the profit and loss account and the other two use information from both that account and the balance sheet.
    Gross profit
    This is calculated by