Monthly Archives: May 2015

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. 

Reference List:

MSI Global Alliance admits accounting firm in Germany

A2MSI Global Alliance, a leading international association of independent legal and accounting firms, has appointed accounting firm WORTMANN & PARTNER in Germany to its membership. 

Based in Rheda-Wiedenbrück in North Rhine-Westphalia, Wortmann & Partner provides a full range of auditing and taxation services as well as accounting and consulting services. The firm, which has recently been named one of Germany’s Top 50 tax consulting firms by Focus Money, joins MSI with five partners and 45 staff.

Established in 1957, Wortmann & Partner has a diverse client base including industrial engineering and manufacturing businesses as well as service providers. The firm’s clients are mostly mid-sized and operate in national and international markets.
MSI’s chief executive, Tim Wilson, commented, “I am very pleased that Wortmann & Partner have joined MSI. They are a very well-established, highly respected firm in the economically strong area of Westphalia. Their joining further strengthens our presence in Germany and I know they will contribute a great deal to MSI internationally.”

Volker Ervens, partner at Wortmann & Partner, said, “We are very excited about joining MSI. The code of conduct, which all members have to follow and respect, and the strong position of MSI in the worldwide market have been very convincing to us. We look forward to getting to know many members at future conferences and through joint efforts to fulfil our clients’ needs.”

The appointment of Wortmann & Partner adds further strength to MSI’s growing presence in Germany and follows only a few months after the recent merger of MSI’s German founding member Abels Decker Kuhfuss & Partner (now ADKL) with ex-Moore Stephens firm Dr. Müller, Haeb & Partner.

About MSI Global Alliance

MSI is an international association of independent legal and accounting firms. With 240 carefully selected member firms in more than 100 countries, MSI is one of the world’s leading associations. MSI was formed in 1990 in response to the growing need for cross-border co-operation between professional services firms.

In 2013, MSI Global Alliance was awarded “Association of the Year” by the International Accounting Bulletin, the leading authority of the global accounting industry which regularly analyses firm performance and best practices. For more information on MSI and its member firms, please visit www.msiglobal.org