Category Archives: Finance

Are Retirement Annuities still useful?

Retirement annuities are often misunderstood and many people, or their parents, have had bad experiences with tem in the past. This sentiment often relates to the investment performance and possibly also the charges related with these products. Some facts need to be considered before you discard this very useful investment vehicle for yourself.

When talking about financial planning and investments it is not uncommon that people say and hold opinions such as “I don’t like retirement annuities, they are terrible investments!” Usually it has to do with the performance and people can’t understand how after 10 years of contributing to a retirement annuity (RA), it is worth less than the amount they have put in.

This sentiment leads to a variety of discussion points, ranging from the fact that an RA is an investment vehicle or product wrapper, not an investment strategy or fund itself, to the fact that returns achieved are as a result of the underlying asset classes invested into, and will thus vary from one RA to the next.

What is meant by an investment vehicle or product wrapper?

Simply put often an investment vehicle, or product wrapper, has been created by legislation and usually tax legislation. Well at least that is the case for RA’s.

The government has for a long time been concerned that people do not save enough money for retirement, and ultimately people that are unable to work due to old age become a burden on the state. The state therefore has to address this and has therefore created specific tax treatments for RA’s in order to encourage people to use them to save for retirement specifically.

The idea is not to get too technical here, as the purpose of this information is not to go deeply into the tax benefits of RA’s save to say that the product wrapper known as an RA is merely one that carries these tax benefits. Briefly however, the contributions that are paid towards an RA are deductible from your gross income, the growth within the product is tax free, and on retirement there are certain tax free portions and thereafter different (more beneficial) tax rates for the lump sum benefits which do get paid out. You should get more information on this from your financial advisor.

What is meant by a fund?

If one understands that the RA is merely the product wrapper used and that this has nothing to do with the investment funds chosen for the actual money that is invested in this wrapper then we can start talking about investment performance. It should now be clear that the two are separate matters. Although it did not necessarily work this way in the past, but most modern RA’s now have a choice of funds the same, or at least very similar, to the funds used to make any other investment. One can even get an RA with a managed stock portfolio as an underlying investment.

The choice of funds is now up to you, with guidance from your financial advisor. The underlying assets of the fund must be matched to the objectives you are trying to achieve and your risk profile as an investor. As the objective of RA’s – retirement, is something that will usually only happen many years down the line you have the time available to use a lot of equity in your portfolio. Equity will give you the best returns over a longer period of time.

So by choosing the write underlying investment portfolio for your product wrapper, in this instance the RA, you would find that the investment performance of your RA should be no different had you invested in the fund directly and not used an RA, except that you have added tax benefits, which can actually boost your returns. You now have the tax benefits of the RA product wrapper and the performance of the fund you chose to invest in. Now your only hurdle is choosing the right underlying investment.

This article is a general information sheet and should not be used or relied upon as professional advice. No liability can be accepted for any errors or omissions nor for any loss or damage arising from reliance upon any information herein. Always contact your financial adviser for specific and detailed advice.  Errors and omissions excepted (E&OE)

12 Tips to be Financially Fit

Enough talk of financial doom and gloom. Try these 12 practical ideas to take your money status from out of shape to financially fit.

1. Prioritise your financial needs

Without a sense of priorities, you’ll have limited success in planning your budget. Decide what you most critically need to spend your money on, and develop a realistic spending and savings plan. If your children’s education is a key concern, then list it as a priority area and move that flatscreen TV down the list.

2. Call in the experts

A meeting with a financial planner is the first step on the road to financial independence; what follows is entirely up to you. A good qualified planner will take a holistic view of your financial situation and will suggest a plan to help you reach your goals by considering your risk profile, life stage, financial position and time available to reach those goals.

3. Clear and avoid unnecessary debt

Financially stretched or not, the last thing you need is excessive debt. This can be defined as debt that you have incurred to buy things that you don’t really need. Through careful planning with your financial planner, try to pay of all your expensive debt such as your credit card or personal loans. Anything bought on credit ends up costing you a lot more than the original price, so save up to buy something rather than paying it of – and save on interest!

4. No credit cards

With no monthly credit card payments, you will be able to purchase more things in cash, and you can avoid credit purchases and the interest payable that comes with credit. To remove the temptation of clocking up credit card debt again, leave your card at home or commit to only using it for emergencies.

5. Plan for your old age

You are not able to generate an income forever, so make sure your financial plan makes full provision for your retirement. Your planner can suggest retirement savings options that can accommodate your budget and financial goals. Ask your financial planner about the tax benefits of taking out a retirement annuity (RA).

6. Protect your income

Just as you should insure your prized possessions, such as your car or house, it is important to protect your greatest asset, your ability to earn income. This asset can disappear in a flash, for instance if you are disabled in an accident or if you lose the ability to work due to serious illness. Most people think it won’t happen to them, but it really isn’t worth taking that chance. A range of income protector plans or disability cover options are available from financial services providers to safeguard yourself if you are no longer able to work.

7. Quit pricy bad habits

Smoking doesn’t just spell bad news for your health. It’s also bad news for your pocket. Depending on how much you smoke, quitting the habit can save you about R600 per month (or R7 200 a year). Also, a non-smoker generally pays lower life insurance premiums and is healthier, which means fewer visits to the doctor and saving on medication costs.

8. The s-word…

If you want to achieve your financial goals and live your dreams, you simply have to start saving. If your employer offers you an annual increase, allocate a portion of it to savings before you get used to having the extra money in your pocket. Better yet, set up a monthly savings account debit order on the day you get paid! That way you won’t miss the extra money, as it will feel like you never really had it to begin with. You might think you can’t afford to save, but you will be surprised how you can make it work if saving is your priority.

9. Work on your spending habits

It’s easy to spend our hard-earned salary on less important expenses – money that could be used to achieve a particular goal, or for emergency savings. Because it’s so easy to “swipe the plastic”, leave your credit cards at home and try to only bring them out in emergencies. Watch out for cash leakage. If cash in your purse disappears – leaving you with nothing to show for it – take note of what you spent it on.

10. Plan your spending

Plan purchases. Only buy what you planned to buy. Make a shopping list and stick to it so you don’t overspend. When buying big, expensive items, do an online search for price comparisons. Always ask yourself: Do I really need this? If the answer is no, then put the item back and walk away.

11. Make sure you have a Will

Everyone should have a Will. Not only does will it indicate the beneficiaries of your estate when you die, it also helps to ensure that your last wishes are known and understood. For example, you may have very specific instructions on who should take care of your minor children should you die unexpectedly. Having a Will means that your family and friends will be comforted during a very difficult time in the knowledge that your last wishes were clearly communicated.

12. Plan for the longer term

Once you’ve put everything into place, set your vision on the longer term. It’s well and fine to plan one year in advance, but to really achieve your goals, you need to think further ahead.

By Karin Muller, Head of Growth Market Solutions at Sanlam

This article is a general information sheet and should not be used or relied upon as professional advice. No liability can be accepted for any errors or omissions nor for any loss or damage arising from reliance upon any information herein. Always contact your financial adviser for specific and detailed advice. Errors and omissions excepted (E&OE)

Financial assistance and the Companies Act

One of the more significant changes that the “new” Companies Act, 71 of 2008, brought about was that a company may now provide financial assistance to prospective shareholders to subscribe for shares in that company. In other words, it may lend persons money to enable them to subscribe for shares in the lender (although other forms of financial assistance is also contemplated – see below). Previously, in terms of section 38 of the now repealed Companies Act, 61 of 1973, this was not allowed.

In terms of section 44 of the “new” Companies Act, financial assistance by a company would include extending a loan, guarantee or the providing of security to enable a person to obtain funding for purposes of acquiring shares in that company. Section 44 seeks to regularise such instances of financial assistance however, and this would extend beyond the mere granting of a loan to a would-be shareholder. The wide definition of “financial assistance” makes it clear that the section covers various scenarios and also specifically where financial assistance by a company is provided to anyone not only for the purpose of enabling him or her to subscribe for shares in that company, but also if the assistance is to enable shares to be acquired in a related company.

The purpose of the provision is quite clearly to protect existing shareholders. For example: if a company were to lend money to a prospective shareholder who is subsequently unable to repay the assisting company, that company would have effectively diluted the shareholding interests of the existing shareholders (who would have paid cash for their shares), whilst the new shareholder who is unable to repay the company still has an interest left in the company (and indirectly therefore to the cash subscription proceeds of the other shareholders).

Notwithstanding the potential negative effect of allowing shares to be subscribed for in a company on loan account, it is foreseeable that such financial assistance may be required from time to time for genuine commercial purposes and transactions that would otherwise not have been feasible. B-BBEE transactions are an excellent example of this.

For a company to give financial assistance to a would-be shareholder, the directors of the company must be satisfied that the financial assistance is fair and reasonable to the company, and further that the company will be solvent and liquid thereafter. They must also ensure that this is not in contravention of the company’s Memorandum of Incorporation. If in breach of any of these conditions, the directors may potentially be held personally liable. Typically, the shareholders of the company must also approve thereof by way of a special resolution.

This article is a general information sheet and should not be used or relied upon as professional advice. No liability can be accepted for any errors or omissions nor for any loss or damage arising from reliance upon any information herein. Always contact your financial adviser for specific and detailed advice. Errors and omissions excepted (E&OE)

Financial assistance to directors

A company lending money to its directors may not be as simple a process as it may initially appear to be – not even in the case of so-called “one-man” companies. There are various requirements in the Companies Act, 71 of 2008, to be adhered to, as well as certain potential pitfalls in the Income Tax Act, 58 of 1962, that one should be aware of.

Section 45 of the Companies Act regulates the lending of money by companies to their directors. The scope of the provision also extends much further than a loan itself: it covers any form of “financial assistance” to directors, which specifically includes “lending money, guaranteeing a loan or other obligation, and securing any debt or obligation”.

The board of directors of a company must authorise the financial assistance to be provided to a director, and the board resolution to this effect must be circulated to all shareholders as well as trade unions representing employees of the company. The company’s board must further be satisfied that the financial assistance is fair and reasonable to the company, and further that the company will be solvent and liquid thereafter. They must also ensure that this is not in contravention of the company’s Memorandum of Incorporation. If in breach of any of these conditions, the directors may potentially be held personally liable for any damages.

From a tax perspective, a director of a company is by definition also an employee of that company. This means that the director may be liable for tax on a fringe benefit if a loan is extended to him or her which does not bear market-related interest rates. For purposes of the Income Tax Act, this will be the case where the loan bears interest at less than the repo rate plus 100 basis points (see paragraph 11(1) of the Seventh Schedule to the Income Tax Act). The value of any such fringe benefit will be included in the director’s gross income for tax purposes and taxed accordingly.

Fringe benefits are not the only potential tax concern for companies with loan accounts in favour of themselves against a director. Quite often directors are also shareholders in a company (which is especially the case for small and medium-sized companies). In this case, an interest free loan, or one with interest below the repo rate plus 100 basis points, will give rise to a deemed dividend in the hands of the director-shareholder. Effectively, the deemed dividend will be the interest charged too little. This amount will be calculated on an annual basis, and attract dividends tax at 15% (section 64E(4) of the Income Tax Act) which will be for the director’s account.

This article is a general information sheet and should not be used or relied upon as professional advice. No liability can be accepted for any errors or omissions nor for any loss or damage arising from reliance upon any information herein. Always contact your financial adviser for specific and detailed advice. Errors and omissions excepted (E&OE).

Women have the right sentiment for investing

Woman_bSome recent studies seem to suggest that woman have the right skills and attitude to be great in taking on matters regarding their financial planning and investments. However, other studies seem to suggest that they lack the requisite confidence to do so. The evidence seems to suggest that woman should take the lead within their families in this department.

According to a report released recently by SigFig, a US based company assisting direct investors with their portfolios, female investors enjoyed returns of 12% higher than their male counterparts over the year the report covers. Assuming this performance trend continued over a thirty-year period, a woman with R100 000 (we’ll use rands, even though the report uses dollars) invested would earn R58 000 more than a man. Men were also revealed to be 25% more likely to lose money in the market than women. Why is that?

It would seem that men ‘churn’ (sell off and buy something else) their portfolios 50% more often than women. Churning is particularly detrimental to investment returns. For example, in 2014 frequent traders (or investors with an annual investment portfolio turnover of 100% and above) experienced average net returns of only 0.1% compared to the 4.7% enjoyed by other investors.

Overconfidence and cautiousness?

A likely reason behind the lower returns earned by men and their tendency to churn their portfolios is overconfidence. According to the study, men are typically one and a half times more confident than women that they will better the market in 2015.

All things considered, the proverbial playing field evens out later on in life. This is evident in how a typical 25-year-old woman invests in a similar way to a typical 35-year-old man, while a 55-year-old man invests in a similar way to your average 65-year-old woman.

Despite being more successful investors than men on aggregate, women tend to be less empowered when it comes to their finances. A Fidelity Investments Money Fit Woman Study indicates that 8 in 10 women refrain from discussing finances with people they are close to. Interestingly, while 82% of women feel confident when it comes to managing a monthly budget, this is not the case when it comes to long-term financial planning. So whereas women are confident they can balance a checkbook or manage the family budget without help, they are less confident regarding planning for their financial needs during retirement or selecting the right financial investments.

Indeed, a lack of confidence is a leading cause of financial illiteracy among women, despite it being a top concern of theirs. For example, while 77% of women cited feeling comfortable talking to a doctor on their own about medical issues, just 47% said they would talk with a financial professional on their own. However, 70% of women currently not working with a financial professional would be motivated to do so in the future.

Money and marriage?

All too often, one spouse will take care of the finances. And all too often, it is men who take the proverbial wheel in steering the course of their family’s financial future. According to Fidelity’s study, just 41% of partners make joint retirement investment decisions and only 17% of the respondents were “completely confident” that their spouse was able to take responsibility for the family’s retirement finances.

Couples should really decide together on their family’s needs and goals in both the short and long term. Together they need to agree on and take ownership of their financial plan if, ultimately, it is to work for them both. Eventually, when you are forced to live with the consequences of all the small financial decisions you made earlier on in life, this can lead to regret.

Women need to take advantage of their inherently more astute investment instincts and ensure that they are fully informed regarding their financial affairs, so as to take control of their tomorrow. It is only when you know what your tomorrow holds that you can truly welcome it.

This article is a general information sheet and should not be used or relied upon as professional advice. No liability can be accepted for any errors or omissions nor for any loss or damage arising from reliance upon any information herein. Always contact your financial adviser for specific and detailed advice. Errors and omissions excepted (E&OE)

Appointing a financial manager: Do you know what to look for?

A2Ideally the candidate to appoint as financial manager must be qualified for the post in terms of sufficient knowledge and relevant experience. There is, however, a third consideration which are often overlooked or not considered to be of the same importance as knowledge and experience, and that is soft skills. The rest of this article will discuss each of these three considerations in more detail.

Qualifications required

A formal financial qualification e.g. a bachelor’s degree is the minimum educational requirement for a financial manager. Depending on the level of complexity of the busniness’ finances, a post graduate degree or a professional qualification e.g. Chartered Accountant, might also be necessary.

Being a member of a professional organisation related to a candidate’s financial qualification can help to ensure that his/her knowledge is up to date with current financial standards and legislation.

Experience required

Appropriate work experience is usually a requirement but it’s not always possible to find someone with the ideal experience. If a candidate does not have ideal experience, try to determine if he/she has any relevant theoretical knowledge, is eager to learn and able to absorb new information quickly.

Soft skills required

Being a financial manager requires you to work with people in order to reach the business’ financial goals. If a candidate does not have the necessary soft skills, he/she won’t be able to manage the people below them successfully.

Consider testing of candidates on the shortlist by a psychologist to determine which of them have the best fit for the job in terms of personality and soft skills before making the final decision on who to appoint as financial manager.

Ultimately, you probably won’t find the ideal candidate with exactly the right knowledge, experience and soft skills you are looking for. It is highly likely that you will have to compromise on something with each candidate. If you have to choose between two people where one have the knowledge and experience but not a positive attitude, and the other one lacks some of the knowledge and experience you want, but have an excellent attitude, it might be better to hire the person with the right attitude as they can always get training to gain knowledge, but you can’t really train someone to have a better attitude. In short, appoint for attitude and train for knowledge.

To determine a candidate’s general attitude and handling of situations involving, amongst other things, conflict, pressure and staff problems, ask how he/she handled these kind of situations in the past. It is widely accepted that past conduct is in general a good indicator of future conduct.

Other basic soft skills that would be required in the role of a financial manager are:

  • Communication skills: Good listening skills and can explain complex information in a way that other people can easily understand
  • Organizational skills: Able to manage time, people and money
  • Attention to detail
  • People and leadership skills: Is assertive but kind and sensitive towards employees and able to motivate people
  • Problem-recognition and problem-solving skills: Ability to identify and overcome unexpected issues

A word on following up of qualifications and work references

If possible, go to the trouble to confirm that a candidate indeed have the qualification(s) and membership status he/she claims to have by following up with the relevant tertiary institutions and professional bodies.

It is extremely important to follow up on the references supplied by candidates. You can gather valuable information about a candidate’s general work habits and attitude that might not be available through other sources.

Appointing a financial manager can be an expensive and time-consuming exercise and have a significant positive or negative influence on the future of the business. Take the time to do the homework and make sure you pick the best possible candidate for the job. If none of the candidates is a good fit for the post of financial manager, it could be worth your while to advertise again and conduct a new round of interviews until you find the most suitable candidate.

This article is a general information sheet and should not be used or relied upon as professional advice. No liability can be accepted for any errors or ommissions nor for any loss or damage arising from reliance upon any information herein. Always contact your financial adviser for specific and detailed advice.

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Do you use a monthly financial checklist? If not, you might miss something important!

A3The primary purpose of business is to generate positive cash flow and make a profit, both of which are determined by two factors: money coming into the business and money going out of the business. As long as the money coming in is more than the money going out, you will be smiling. But what if the scenario changes and money going out is more than money coming in?

Will you even know if your business is not making a profit and/or generating enough cash to stay afloat? If you check the financial figures sporadically you might pick up that something’s going wrong eventually but then it might be too late to save the business. If you check the figures religiously once or twice a month and make comparisons between months, you will discover quickly when profitability and cash flow changes for the worse, and you will be able to take steps to rectify this sooner rather than later and have a fair chance of saving your business.

Checking up on your business’ financial affairs at least every month is a good business practice that will help you as a business owner/manager to stay on top of what’s going on in the business. It is crucial to stay in touch with what’s happening elsewhere in the business especially if you are not involved in the day to day running of the business or if the business have grown and you had to delegate some of your workload to others.

Using a checklist regularly and interpreting the results accurately, enables a business owner/manager to get a bird’s eye view of the business in a relatively short period of time. Some of the most important points which should be included in a monthly financial checklist are:

  • Check that accounting software is updated
  • Make sure financial data is entered into the accounting system regularly and accurately
  • Ensure that stocktakes are performed regularly and reconciled with accounting balances; follow up on discrepancies between the counted stock and the theoretical stock balance on the accounting system; be on the lookout for damaged and/or obsolete stock which must be removed from the accounting system
  • Consider implementing a policy of invoicing clients for goods and services as soon as it has been delivered to them
  • Check all bank reconciliations (including petty cash and investments), and follow up on discrepancies and long-outstanding items on the bank reconciliations
  • Check debtors’ reconciliations and follow up on long outstanding amounts
  • Check creditors’ reconciliations and compare with approved list of suppliers; follow up on long-outstanding items on the creditors’ reconciliations
  • Implement periodical asset stocktakes and reconcile results with fixed asset register
  • Review salary records for reasonability of salary deductions, timely payment of PAYE to SARS, etc.
  • Draw up a budget for a future period and compare the actual results for that period with the budget – investigate any material variances between budgeted and actual amounts, keeping in mind that a budget is a forecast and will never be 100% accurate

Indicators of the financial health of a business are calculated from the financial reports and financial statements. By paying attention to these indicators and comparing them from month to month, you will be able to spot trends in the business and the industry in which it operates, and take appropriate action if and when required.

No two business’ checklists will look the same as every business is unique so use caution if you use a standard checklist that has not been customised for your unique business setup. Lastly, make sure you know how to interpret the results you get from working through the checklist otherwise the use of the checklist will just be a waste of time.

If you would like to implement the use of a monthly financial checklist in your business or improve the financial checklist you are currently using, do contact your financial adviser for professional assistance and advice suited to the specific needs of your business.

This article is a general information sheet and should not be used or relied upon as professional advice. No liability can be accepted for any errors or ommissions nor for any loss or damage arising from reliance upon any information herein. Always contact your financial adviser for specific and detailed advice.

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Budgets: Are they worth the effort?

A7A lot of small businesses are managed by the owner, especially in the early years of a business’s existence. As the owner is intimately involved in the day to day operations of the business, it is easy to keep control of expenses. As a business grows, however, it may become necessary to appoint employees to assist the owner in running the business.

It is inevitable that a time will come where the owner will have to delegate certain financial powers to employees and trust them to spend the business’s money wisely. This is where a budget and the budgeting process can be of immense value.

To put it simply, a budget is a financial plan for a certain period in the future based on a combination of the current financial position and a projection of expected income and expenses for said period. Combining a business’s income, expenses and financial goals into one overall plan will give a clear picture of where the business is at in financial terms and how to proceed to reach those goals.

Drawing up a budget requires that the owner and/or management think about goals for the business and how to finance them. If there is more than one goal, the goals will have to be prioritised to determine which goal(s) the focus will be on for the period of the budget.

A thorough budget should ensure that the business have sufficient capital available when needed for large expenditure items like replacing expensive equipment or taking on new business ventures. Including the financial implications of future growth and expansion in the budget will ensure that the business has capital on hand to allow it to make quick decisions about opportunities for expanding operations.

Budgeting can help you to determine in advance when you will need money and how much, thus preventing crises due to a shortage of funds. It is especially important for businesses with seasonal business cycles to have a safety net for the months when business will be slow.

A budget acts as a guide to help employees understand what the owner’s priorities for the business are. Typically a budget will set targets for expenses and income for each department or cost centre. It is, however, important that the targets are realistic and achievable, and that each manager knows what the owner’s expectations are for the period of the budget.

During the process of drawing up a budget each expense item is put under the microscope. It is the ideal opportunity to determine which expenses are essential and which ones can be eliminated.

A budget can assist management in controlling expenditure by establishing boundaries in order to eliminate spending that is not in line with the business’s plans for the future. Limiting spending on expenses which are not part of the plan ensures that money is allocated to the important areas.

Using a budget enables the owner and management to measure their actual progress and performance against the budget. If they see that they are deviating from budgeted figures they can take appropriate action or, if the budget was unrealistic, the budget might have to be adjusted. A budget is a flexible tool and needs to be adjusted if it does not work or if the circumstances on which the budget is based, changes.

As market conditions, technology and employment requirements change all the time, a budget will have to be reviewed regularly to be of any real value.

Knowledge is power and drawing up a budget will give the owner detailed knowledge of the current position, potential destinations and possible ways to finance the journey from where the business is now to where it can go. To answer the question posed in the heading of this article, whether budgets are worth the effort needed to draw them up, the answer would be a resounding “Yes”!

This article is a general information sheet and should not be used or relied on as professional advice. No liability can be accepted for any errors or omissions nor for any loss or damage arising from reliance upon any information herein. Always contact your financial adviser for specific and detailed advice.

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This article is a general information sheet and should not be used or relied on as professional advice. No liability can be accepted for any errors or omissions, nor for any loss or damage arising from reliance upon any information herein. Always contact your financial adviser for specific and detailed advice.

Financial ratios: What do they mean? (Part 3)

A1Ratio analysis can be used when financial information needs to be simplified to make it possible to interpret and compare the information. Banks often do ratio analysis when they need to decide whether to lend money to a client or not. If a business wants to open an account with a supplier, the suppliers often use ratio analysis to determine the financial health of the business before deciding if they will sell to the business on credit.

In Part 1 and Part 2 of this series of articles on financial ratios, the limitations of using ratios have been mentioned. However, there are also certain advantages to making use of ratio analysis. Some of these advantages are:

  • Ratios simplify the relationships between different amounts in a way that is easy to understand.
  • Ratio analysis allows the user to get a bird’s-eye view of the changes that have taken place in the financial condition of a business.
  • Ratio analysis makes it easier to compare different businesses with each other.
  • Comparisons can be made in the same business, between different years or divisions, to monitor the efficiency and performance of business units.
  • Ratio analysis can be used in planning by using past ratios to forecast future financial situations e.g. when drawing up a budget. 

Financial risk ratios

Financial risk ratios, also known as solvency ratios, are used to determine the long term financial health of a business by determining whether the business carries too much or too little debt.

  • Debt ratio (also known as gearing):

Formula: Liabilities/Assets

A business can finance its assets with capital from the owner(s) or money borrowed from a bank or similar institution. The debt ratio determines the proportion of the assets of a business that are financed through debt, e.g. a debt ratio of more than 0.5 means more than half of the business’s assets are financed through debt. A debt ratio of less than 0.5 means most of the business’s assets are financed through capital (equity).

  • Equity ratio:

Formula: Equity/Assets

The equity ratio is a variant of the debt ratio above. The equity ratio shows the proportion of the assets of a business that are financed through equity.

  • Times interest earned (Interest cover):

Formula: Profits before interest paid and income tax / Interest paid

This ratio indicates whether a business will be able to make the interest payments on its debts from its profits. For example, a ratio of 2.5:1 means that the business earns two and a half times the amount that is needed to cover its interest expense.

  • Free cash flow ratio:

Formula: Cash flow from operating activities – Capital expenditure

The free cash flow ratio gives the amount of cash from operations that is left after a business paid for its capital expenditure. This is the amount of cash that is available to repay loans to banks and loans from the owner(s) to the business, and to make investments.

  • Cash flow coverage ratio:

Formula: Operating cash flows / Total debt

Banks often look at this ratio when they have to decide if they will make a loan to a business as this ratio tells if a business will be able to make capital and interest payments on loans when they become due.

A ratio of 1:1 means the business is in a good liquidity position or in good financial health. A ratio of less than 1 implies that the business does not earn enough profits to be able to pay capital and interest out of its earnings. If a business has a ratio of less than 1, there is a good chance of bankruptcy within the next few years if the business does not do something to improve its financial position.

The above ratios are used to give an indication of the financial health of a business. It is important to remember that different industries have different norms and what is interpreted as a problematic ratio in one industry, can be perfectly acceptable in another industry.

For professional assistance and advice on this topic, please contact our offices.

This article is a general information sheet and should not be used or relied on as professional advice. No liability can be accepted for any errors or omissions nor for any loss or damage arising from reliance upon any information herein. Always contact your financial adviser for specific and detailed advice. 

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Financial ratios: What do they mean? (Part 2)

A2The purpose of ratio analysis is to simplify the financial situation of a business by looking at the relationships between different categories of accounting data.

The amounts used in ratio analysis will normally be read from a set of financial statements.

Two important limitations of ratio analysis which must be kept in mind are:

  • Two people can interpret the same ratio result very differently as there are no fixed guidelines on how the results of ratios must be interpreted.
  • The same result of a specific ratio can be excellent in one industry, but fatal in another industry. It is crucial to interpret a ratio within the context of the circumstances of the business and the industry it operates in, as well as general market conditions.

The first article in the series on financial ratios dealt with liquidity (short-term solvency) ratios and efficiency ratios. This article will discuss profitability ratios, return on investment (ROI) ratios and operating efficiency (OE) ratios.

Profitability ratios

Profitability ratios measure if a business is making a profit or a loss, and whether the ratios are acceptable or not. The rule of thumb is the higher the return, the better the business is at controlling its costs.

Financial ratio Formula What this ratio measures
Gross profit margin Gross profit / Net sales x 100 = x% The percentage of each rand of sales that is left over, after deducting cost of inventory sold, for paying expenses and making a profit
Net profit margin Net profit after tax / Net sales x 100 = x% The percentage of each rand of sales, after all expenses have been paid, that will be left as profit

ROI ratios

ROI ratios are used to calculate the return on an investment made in a business or an asset. The general rule is that the higher the return, the more profitable the investment.

Financial ratio Formula What this ratio measures
Return on assets Net profit after tax / Average total assets* x 100 = x% The average percentage of profit after tax that was made on the business’s investment in total assets
Return on equity Net profit after tax / Average owner’s equity** x 100 = x% The average percentage of profit after tax that was made on the owner’s investment in the business

*Average total assets = (Opening long-term assets + Opening short-term assets + Closing long-term assets + Closing short-term assets) / 2

**Average total equity = (Opening equity + Closing equity) / 2

OE ratios

The result of operating efficiency ratios gives an idea of how efficiently a business is using its total investment in resources. Generally, the bigger the result of the ratio, the more efficient the business is at generating income from its assets and equity investments from its owner(s).

Financial ratio Formula What this ratio measures
Net working capital turnover Sales / Average net working capital^ How many rands of sales are generated for each rand of net working capital
Fixed asset turnover Sales / Average net fixed assets^^ How many rands of sales are generated for each rand of net fixed assets
Total asset turnover Sales / Average total assets^^^ How many rands of sales are generated for each rand invested in the assets of the business
Equity turnover Sales / Average total equity^^^^ How many rands of sales are generated for each rand invested by the owner(s) in the business

^Average net working capital = (Opening net working capital + Closing net working capital) / 2

^^Average net fixed assets = (Opening net fixed assets + Closing net fixed assets) / 2

^^^Average total assets = (Opening assets + Closing assets) / 2

^^^^Average total equity = (Opening equity + Closing equity) / 2

All the above ratios deal in some way or another with how efficient a business is at managing its expenses, income and assets. Remember to interpret all financial ratios against the backdrop of the business’s unique circumstances, taking into account the industry the business operates in and the market conditions for that industry.

For more information on this topic, please contact us for professional assistance and advice.

This article is a general information sheet and should not be used or relied on as professional advice. No liability can be accepted for any errors or omissions nor for any loss or damage arising from reliance upon any information herein. Always contact your financial adviser for specific and detailed advice. 

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