The profit and loss account and balance sheet gives a clear idea of the health of a business, but for many, these statements can be daunting.

Financial ratios help assess performace and get early warning signs of any problems. We can all learn from the unfortunate news about City Link.

Ratios can help companies assess the following:- – Liquidity – the amount of working capital (see Tips 2, 3 and 4). – Solvency – how near to bankruptcy? (Tip 5) – Efficiency – how good is your management. – Profitability – is the business a good investment?

The 5 tips below outline key ratios to consider:-

1. Ratios Explained

The current assets of your business are its cash or assets such as stock, work in progress or debts that can be turned into cash. Current liabilities are your immediate trade creditors and your bank overdraft.

You should always have sufficient current assets to meet current liability obligations. Liquidity ratios indicate your ability to meet liabilities.

2. Current ratio

The current ratio simply shows the relationship of current assets to current liabilities.

In particular, it shows the ability of your business to meet short-term debits with current assets. Current ratio = Current assets Current liabilities The ratio should normally be between 1.5 and 2.

Some people argue that the current ratio should be at least 2, on the basis that half the assets might be stock.

A ratio of less than 1 (that is, where the current liabilities exceed the current assets) could mean that you are unable to meet debts as they fall due, in which case, you are insolvent. A high current ratio could indicate that too much money is tied up in assets, for example, giving customers too much credit.

3. Quick ratio (acid test)

A stricter test of liquidity is the quick ratio or acid test.

The ratio measures your ability to meet short-term liabilities from liquid assets such as cash. Some current assets such as work in progress and stock may be difficult to turn quickly into cash.

Deducting these from the current assets gives the quick assets.

Quick ratio = current assets – stock

Current liabilities

The quick ratio should be normally around 0.7-1. To be absolutely safe, the quick ratio should be at least 1, which indicates that quick assets exceed current liabilities.

If the current ratio is rising and the quick ratio is static, there is almost certainly a stockholding problem.

4. Gearing ratio

The Gearing ratio gives an indication of solvency.

It is normally defined as the ratio of debt) loans from all sources including debentures, term loans and overdraft) to total finance (which includes shareholders’ capital, reserves, long-term debt and overdraft). The higher the proportion of loan finance, the higher the gearing.

Gearing= loans + bank overdraft

Equity + long-term loans +bank overdraft

Ideally, your gearing should not be greater than 50%, although new, small businesses often do exceed this percentage. If cash flow is stable and profit fairly stable, then you can afford a higher gearing.

5. Interest cover

In addition to watching the gearing of your business, bankers will also want to be satisfied that you will be able to pay the interest of any loans.

So they look particularly at how many times your profit exceeds their interest charges. A business with low interest cover may be unable to meet future payments if profits were to fall.

Interest cover= Net profit before interest and tax

Interest charge

Generally, the measure of risk should not be decreasing. There is a problem is the interest cover is lower than 1 and this may indicate potential problems is interest rates were to rise. If it is more than 4, it is very good.

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