What the purpose of financial controls in an organisation?
One of the primary purposes of every business is to earn profit. To achieve this goal, managers need financial control. Managers might for instance, carefully analyse quarterly income statements for excessive expenses. They might also perform several financial ratio tests to ensure that sufficient cash is available to pay ongoing expenses, that debt level haven not become too high, or that assets are being used productively. Or they might look at some newer financial control tools such as Economic Value Added (EVA) to see if the company is creating economic value. The following are some groups of accounting ratios used in organisations
- Liquidity ratios :They measure an organisation’s ability to meet current debt obligations.
- Leverage ratios:They examine the organisation’s use of debt to finance its assets and whether it is able to meet the interest payments on the debt.
- Activity ratios:They assess how efficiently the organisation is using its assets
- Profitability ratios: These measure how efficiently and effectively the firm is using its assets to generate profits.
All these ratios are calculated using information from the organisation’s two financial statements – statement of financial position and statement of comprehensive.
Illustrate the ratios under each category given above.
LIQUIDITY RATIOS
Liquidity of a firm is measured by its ability to satisfy its long-term obligations as they come due. Liquidity refers to the solvency of the firm’s overall financial position – the ease with which it can pay its bills. Liquidity is measured by dividing the firm’s current assets by its current liabilities. The two basic measures of liquidity are the current ratio and the acid- test (quick) ratio.
- CURRENT RATIO
The Current ratio, one of the most commonly cited financial ratios, measures the firm’s ability to meet its short-term obligations
Current ratio = Current Assets /current liabilities
Generally, the higher the ratio, the more liquid the firm is considered to be. A current ratio of 2.0 is occasionally cited as acceptable but a value’s acceptability depends on the industry in which the firm operates
2. ACID-TEST RATIO (QUICK RATIO)
The acid-test (quick) ratio is similar to current ratio except that it excludes inventory, which is generally the least liquid asset. The generally low liquidity of inventory results from two primary factors: (1) many types of inventory cannot be easily sold because they are partially completed items, special purpose items etc, and (2) inventory is typically sold on credit, which means that it becomes an account receivable before being converted to cash
Acid-test ratio = Current assets – Inventory / current liabilities
A Quick Ratio of 1.0 or greater is occasionally recommended, but also the acceptability depends largely on the industry in which the firm is operating in.
LEVERAGE RATIOS (ALSO KNOWN AS DEBT RATIOS)
Leverage ratios of a firm indicate the amount of other people’s money being used to generate profits. In general, the financial analysts are most concerned with long-term debts, because these commit the firm to a stream of payments over the long run.
Generally, the more debt a firm uses in relation to its assets, the greater its financial leverage. Financial Leverage is the magnification of risk and return introduced through the use of fixed cost financing, such as debt and preferred stock. The more fixed-cost debt a firm uses, the greater will be its expected risk and return.
1.DEBT RATIO
The debt ratio measures the proportion of total assets financed by the firm’s creditors. The higher this ratio, the greater the amount of other people’s money being used to generate profits.
Debt ratio = Total Liabilities / total assets
The higher the ratio, the greater the firm’s degree of indebtedness and the more financial leverage it has.
2. TIMES INTEREST EARNED RATIO
The Times Interest Earned Ratio, sometimes called the Interest Coverage Ratio, measures the firm’s ability to make contractual interest payments. The high its value, the better able the firm is to fulfil its interest obligations.
Times Interest Earned Ratios = Earnings Before Interest and Taxes (EBIT)
Interest
A value of at least 3.0 – and preferably closer to 5.0 – is often suggested.
- FIXED PAYMENT COVERAGE RATIO
The fixed-payment coverage ratio measures the firm’s ability to meet all fixed payment obligations such as, loan interest and principal, lease payments, and preferred stock dividends. As is true of the times interest earned ratio, the higher this value the better.
Fixed Payment Coverage Ratio = (Earnings Before Interest and Taxes + Lease Payments)/
Interest + Lease Payments + {(Principle Payments + Preferred Stock Dividends) X [1/ (1-T)]}
T - It is the corporate tax applicable to the firm’s income.
ACTIVITY RATIOS
Activity ratios measures the speed with which various accounts are converted into sales or cash – inflows or outflows
- INVENTORY TURNOVER
Inventory turnover commonly measures the activity, or liquidity, of a firm’s inventory.
Inventory Turnover = (Cost of Goods Sold)/Inventory (closing)
The resulting turnover is meaningful only when it is compared with that of the other firms in the same industry or to the firm’s past inventory turnover.
Inventory turnover can be easily converted into average age of inventory by dividing it into 360 days – the assumed number of days in the year.
2. AVERAGE COLLECTION PERIOD
The average collection period, or average age of accounts receivable, is useful in evaluating credit and collection policies. It is arrived at by dividing the average daily sales into the accounts receivable balance.
Average Collection Period = (Accounts Receivable )/ (annual sales / 360 days)
(Annual Sales / 360) is the average sales per day.
The average collection period is meaningful only in relation to the firm’s credit terms. For example, if the company extends 30-day credit terms to its customers and if its average collection period is 50 days, this may indicate a poorly managed credit or collection department, or both.
3. AVERAGE PAYMENT PERIOD
The average payment period, or average age of accounts payable, is calculated in the same manner as average collection period.
Average Payment Period = (Accounts Payable)/ (Annual Purchases / 360 days)
(Annual Purchases / 360) is the average purchases per day.
The difficulty in calculating this ratio stems from the need to find annual purchases, a value not available in published financial statements.
4.TOTAL ASSETS TURNOVER
The Total Asset Turnover indicates the efficiency with which the firm uses its assets to generate sales.
Total Asset Turnover = Sales /Totals Assets
Generally, the higher a firm’s total asset turnover, the more efficiently its assets have been used this measure is probably of greatest interest to management, because it indicates whether the firm’s operations have been financially efficient.
PROFITABILITY RATIOS
Profitability Ratios measures the firm’s profit in respect to a given level of sales, a certain level of assets, or the owner’s investment. Without profits, a firm could not attract outside capital. Owners, creditors, and management pay close attention to boosting profits because of the great importance placed on earnings in the marketplace.
- GROSS PROFIT MARGIN
The gross profit margin measures the percentage of each sales dollar remaining after the firm has paid for its goods. The higher the gross profit margin, the better – that is, the lower the relative cost of merchandise sold.
Gross Profit Margin = ( Sales – Cost of Goods Sold ) / sales = Gross Profit/ sales
2. NET PROFIT MARGIN
The net profit margin measures the percentage of each sales dollar remaining after all costs and expenses, including interest, taxes, and preferred stock dividends, have been deducted. The higher the firm’s profit margin, the better
Net Profit Margin = Earnings available for Common Stockholders / sales
The net profit margin is a commonly cited measure of the firm’s success with respect to earnings on sales
3. EARNINGS PER SHARE (EPS)
The firm’s earnings per share (EPS) is generally of interest to present or prospective stockholders and management. Earnings per share represent the number of dollars earned during the period on behalf of each outstanding share of common stock.
Earnings per Share = Earnings available for Common Stockholders / Number of shares of Common Stock Outstanding
Earnings per share is closely watched by the investing public and is considered an indicator of corporate success.
4.RETURN OF ASSETS (ROA) (RETURN ON INVESTMENT (ROI)
The return on total assets often called the return on investment; measures the overall effectiveness of management in generating profits with its available assets. The higher the ROI, the better.
Return on Investment (Total Assets) = Earnings available for Common Stockholders/ total assets
5. RETURN OF EQUITY (ROE)
The return on equity measures the return earned on the common stockholders’ investment in the firm. Generally, the higher this return, the better off are the owners.
Return on Equity = Earnings available for Common Stockholders/ equity
