Key Financial Ratios and Accounting Concepts for Business Analysis

Posted on Dec 6, 2024 in Economy

Financial Ratios

Solvency

  • Availability: Available / Current Liabilities (+ or – 0.2, 0.3). Indicates the company’s ability to cover short-term debt with available assets (expressed as X%).
  • Cash (Acid-Test): (Cash + Marketable Securities + Accounts Receivable) / Current Liabilities (+ or – 0.6, 0.7). Shows the ability to cover immediate debts with liquid assets (expressed as X%).
  • Liquidity (Current Ratio): Current Assets / Current Liabilities (>1: Positive Working Capital, <1: Negative Working Capital, =0: Working Capital equals zero). Ideal values are between 1 and 2; above 2 may indicate excessive liquidity.
  • Solvency (or Guarantee): (Real Assets – Goodwill and R&D Expenses) / Total Debt (>1: Company has sufficient assets to cover all debts, <1: Potential bankruptcy).

Debt Management

  • Debt Ratio: Total Debt / Total Assets. Ideal value is 0.5, meaning 50% of financing is external.
  • Debt Structure/Quality: Current Liabilities / Total Debt. A value closer to 0 is better, with 0.5 as the upper limit. Above 0.5 indicates lower debt quality.

Working Capital (WC) = Current Assets (CA) – Current Liabilities (CL)

  • WC > 0: The company has enough resources to cover its debts with current assets and has a financial cushion.
  • WC < 0: The company does not have enough resources to cover its debts with current assets, indicating a temporary financial imbalance (potential short-term solvency issues).
  • WC = 0: The company has just enough resources to cover its current debts.

Returns

  • Return on Investment (ROI) & Return on Assets (ROA): Earnings Before Interest and Taxes (EBIT) / Total Assets. Higher is better; for every €100 invested, the company generates a profit of X.
  • Return on Equity (ROE): Net Profit / Shareholders’ Equity. For every €100 of equity, the owners obtain a net profit of X.
  • Sales Margin: EBIT / Net Sales (Revenue). Measures gross profit from sales; higher is better.

Financial Leverage Effect (FLE)

  • EBIT / (EBIT – Financial Expenses) / Equity
  • > 1: Debt increases profitability.
  • < 1: Debt is not desirable.
  • = 1: Debt does not affect profitability.

Cash Flow Calculation: Net Profit + Depreciation & Amortization + Provisions +/- Changes in Working Capital (Cash flow represents the net variation in liquid assets).

Accounting Concepts and Objectives

Financial accounting is a company-wide information system. This information is summarized in three basic documents: the balance sheet, the income statement, and the notes to the financial statements. Its primary use is for decision-making. The most important accounting objectives are:

  1. Properly identify and assess accounting facts.
  2. Prepare documents that synthesize this information.
  3. Communicate this information to users for analysis and correct interpretation.

Business Equity: The set of assets, rights, and obligations at a specific point in time.

  • Assets: Company property.
  • Rights: Claims against third parties.
  • Obligations: Outstanding debts payable to third parties.

Equity = Assets – Liabilities or Assets = Liabilities + Equity

Mass: In a company, there are two masses: Assets (Goods and Rights) and Liabilities (Obligations), which are equal.

Double-Entry Accounting: A method where each transaction is recorded in at least two accounts, simultaneously reflecting changes in assets, liabilities, and equity.

Accounting Cycle and Phases

The accounting cycle is the process of recording all company transactions during a fiscal year. It is a regular and continuous process, with the end of one year being the beginning of the next. There are three phases:

  1. Initial or Opening Phase: The opening entry records the company’s initial equity. (If it’s a new company, it reflects the initial investment; otherwise, it’s based on the previous year’s closing balances.)
  2. Development and Management Phase: Accounting records transactions chronologically in the journal and ledger using the double-entry method and periodically balances the accounts.
  3. Closing Phase: Preparing all accounts for closing, balancing them, and preparing the final closing balance sheet.

The General Chart of Accounts (PGC) as a Regulatory Framework

The PGC is the legal regulation in Spain that contains the criteria companies must follow to prepare accounting documents.

Economic and Financial Analysis of the Company

Analysis is used to make decisions to improve company management. It studies the composition of the company’s assets to determine financial balance. It also examines returns to make decisions to increase them.

Average Inventory Period (AIP) = Days of Inventory + Days of Production + Days of Collection

AIP = DIP + DOP + DOC

Average Payment Period (APP) = AIP – Days of Payment to Suppliers