Monitor Financial Performance

Monitoring and reporting on financial performance targets are essential for a successful financial strategy. Using spreadsheets or other manual means to track even the most basic and simple metrics like revenue, costs, and income is time-consuming and can lead to errors. It becomes increasingly difficult to maintain this data and keep the information up to date, especially when the small business grows, and its transaction volumes rise.

Financial or accounting systems, such as MYOB and Xero, are digital technologies that help to automate most of this effort and can provide management with reports showing the selected KPIs and the achievement against targets. Using these available systems and digital technologies reduce errors, employee time and effort. They can also assist in providing real-time or near real-time reports and show trends. All this will help in faster and better decision making. They can help in analysing data to show the extent to which business operations have met the financial goals. Using the result of data analysis, management knows whether they are on track to meet their business objectives or if they need to adjust their strategies.

When using digital technologies to monitor and report on financial performance targets and analyse data you need to:

• Ensure you choose the suggested technology for each monitoring or reporting activity
• Follow the guides on how to use each digital technology
• Receive training when required
• Review the reports and the statements created using digital technology for accuracy
• Rectify any errors that might have occurred

Financial Performance Targets and Financial Goals

Financial performance helps determine the health of a business. To ensure you are on track to meet your business plan objectives and financial goals, you need to measure your venture’s financial performance regularly. Financial performance management is the process of managing and monitoring financial results by an organisation. The main purpose is to compare the actual results against budgets, forecasts, and targets. This helps a business adjust as necessary and be better equipped to meet its business goals.

Your financial goals will be derived from your business goals. It is not enough to have long-term goals. You must focus on short-term financial goals too. You must not only look inwards while setting your goals; ensure that you study the environment too. This includes understanding the regulatory and economic environment.

For instance, there is no point in setting aggressive growth goals when there is a downturn in the economy. Instead, you can, at that point, focus on efficiency goals, like reducing your expenses or improving your margins.

You should also study your competition before setting goals and targets. A comparative analysis of your competition may provide you with new opportunities and ideas.

Some financial goals can include:

• Revenue growth
• Cost reduction
• Improved margins
• Debt management
• Cash flow management

You need to set targets for each of the KPIs you have selected based on your business objectives and financial goals. These need to be SMARTER while discussing the selection of KPIs.

For instance, if one of your primary financial goals is debt management or management of the funds your business owes, one of the key indicators you should monitor and track is the DCR. You may set a target for your DCR to be 2. To meet your target, you may need to increase revenue, reduce expenses, or reduce your debt. You may consider meeting with your lenders to renegotiate the loan so that it has a longer duration, thereby reducing your interest outflow. Another option will be to liquidate some of your assets that are not contributing to growth or revenue.

Monitoring Financial Performance

You need to identify the key areas that drive your financial performance and measure them by selecting your KPIs. You also need to ensure you have set targets or established benchmarks so that all employees clearly know what they are working towards. To communicate your strategic vision effectively, you need to break down your strategic objectives into smaller measurable targets. This makes the process of communicating and monitoring them easier.

Monitoring financial performance involves studying the performance of the business against selected KPIs. It helps track whether you are on the right path towards achieving your financial goals and how well is your business performing against industry or internal benchmarks. It also helps you to get early warning signals ahead of adverse developments.

Monitoring involves supervising activities in progress to ensure they are on-course and on schedule in meeting your objectives and performance targets. A primary responsibility of the senior manager, professional advisors and/or Board of a small business is to understand the financial position of the business. They need to react accordingly to assure accountability for business resources and evaluate the ability of the business to meet short and long-term financial goals.

To ensure effective monitoring of the financial performance of your business, you need first to answer the following questions:

1. What are the elements that can be monitored?
   • With what degree of accuracy?
2. How will the activity be monitored?
   • Will you monitor them internally or with help from specialists?
3. Who will be responsible for monitoring the same?
   • Ensure the accountability of monitoring the different elements is clearly laid out.
4. When will the monitoring results be reviewed?
   • Will it be ad hoc based on need, or at periodic intervals?

Once you have selected your KPIs and decided on the targets or benchmarks you are aiming for, you need to set out the monitoring frequency for each element and identify the person or department responsible for tracking the element. To monitor your financial performance, compare the output and performance data with your KPIs. Determine business gaps and areas of excellent performance. Using available systems will help you monitor, analyse and report more effectively and without errors that may creep in if you attempt to do the same manually. You must also track changes from year to year and the trends, if any, that are emerging to monitor your progress and determine if you are on the correct path to reach your financial objectives.

Reporting Financial Performance

You also need to finalise the reporting method, format, and frequency for reporting performance. Different stakeholders will need to be notified about the targets and the achievements. Reporting can be done at different frequencies, and it may vary between businesses. Even within a business venture, the reports may be customised for different audiences.

For instance, different function heads may need to be provided with their efficiency ratios every month to be able to track their performance against the targets or benchmarks and take corrective action. Investors and lenders may wish to see the same only on a quarterly, half-yearly or yearly basis, only to get a sense of the direction the business is headed in.

Normally the standard followed by most businesses for reporting financial performance is as given below:

Monthly review against targets/benchmarks	Key metrics and ratios
Mnonthly analysis against budget	Profit and loss Balance sheet Cash flow
Quarterly update of actuals	Forecast
Semi-annually or annually progress review	Financial plan
Ad-hoc	Significant events as and when they occur Updates on large expenditure

Often the terms financial reports and financial statements are used interchangeably. Financial reports can be any report that contains data about monetary matters and include financial statements. Financial statements are more formal and standardised reports that are presented as per International Financial Reporting Standards (IFRS). These standards are set by the International Accounting Standards Board and provide a common understanding of how businesses should maintain and report their Financial Statements. Financial statements include the balance sheet, the profit and loss statement, the cash flow statement and the statement of change in owner’s equity. They can also include notes comprising significant accounting policies and other explanations. Key features of preparation and interpretation of these financial statements will be covered later in the next section.

In addition to these financial statements, financial reports can include a variety of reports that are prepared at the frequency and format required by various stakeholders. These reports may include accounts receivable aging reports, stock records, and customised reports showing the performance against targets for selected KPIs. They may contain a birds-eye view or can be granular depending on the needs of the business.

Financial performance reporting should:

• Show impact of business operations on financial performance
• Show achievement of or variance against targets
• Highlight trends and forecast

The main purpose of financial reporting is to monitor, analyse and report financial performance.

It helps in the following:

• Analysing the usage of resources, cash flows, operational performance, and financial health of business ventures
• Decision-making and aid in managing the business according to its objectives. Financial Statements, financial analysis and forecasts are tools that aid in business planning
• Communicating with external stakeholders like investors and lenders. Investors will use it to judge the attractiveness of putting funds in your business, and creditors will use them to access your debt-servicing capacity
• Complying to legal and regulatory requirements

Financial Reports Preparation and Interpretation

This section will discuss the key aspects of some critical financial reports used in financial management.

Balance Sheet

The Balance Sheet is a summary of all your business assets – what your business owns and liabilities – what your business owes. At any point in time, if you sell all your assets to pay off your liabilities, the balance that is left over is the money you will have. i.e., the owner’s equity. Hence there are three sections of any balance sheet, which are represented by the equation:

It is also called a Balance Sheet as at any point in time, the two sides of the equation always balance out.

The first step of Balance sheet preparation is to decide on the reporting period (this could be quarterly, half-yearly or on an annual basis). The last date of the reporting period is the reporting date.

You start by identifying all your assets and classifying them as Current or Long-Term (Non-Current) Assets as given below:

Similarly, you will identify and classify all your liabilities into Current and Long-Term Liabilities. Your liabilities can include items shown below:

To your Total Liabilities, add your shareholder’s equity. This total should match your Total Assets calculated above.

To analyse and interpret a balance sheet, you need to use financial ratios. The main feature of the balance sheet is that it is prepared to show a snapshot of the business’s finances at a particular point in time. Using financial ratios, you can interpret the liquidity and solvency position of the business from the balance sheet. A balance sheet provides a clear and accurate presentation of the business’s assets, liabilities, and shareholder’s equity for better interpretation.

ActionCOACH Business Coaching is a YouTube channel that gives business tips on business planning and profit improvement, amongst other advice. Watch the video below to know about how to read a balance sheet.

Profit And Loss Statement

Profit and loss statement shows the profitability of your business over a specific period. It Is mostly produced for a month, a quarter of a year but can cover any period. It is the most useful financial report that shows you, as a business owner, where your business is doing well and where it is struggling. It shows a snapshot of the revenue and expenses of the business over a specific period. Businesses normally prepare their P&L statement monthly to track their financial performance. Investors and lenders may wish to see your P&L statements for a longer period.

To prepare your P&L statement, you need to follow the steps given below:

1. List your COGS
2. Calculate gross profit
   • Sales-COGS
3. List your operating expenses
4. Calculate EBITDA
   • Gross profit - Operating expenses
5. Calculate net profit
   • EBITDA - Interest - Depreciation - Taxes

In your calculations, as shown above, a negative number for profit is your loss.

There are two ways to analyse and interpret P&L Statements:

• Horizontal Analysis – This looks at each line item in your statement across periods. This helps know how each item is changing over time. This helps you identify patterns. For instance, your revenue jumps every Christmas showing your holiday sales are higher than normal sales.
• Vertical Analysis – This looks at the relative size of each expense item to revenue. For instance, how much is your payroll or advertising expense to revenue? Are there trends that you can observe?

To interpret the P&L statement, you will use financial ratios, especially profitability ratios. In addition, you need to look for the following:

• Revenue or Net Sales: This is total sales less discounts and returns. This should increase between periods as falling revenue is a sign of trouble for any business. Spitting your sales by individual products will let you know which products are selling and which need more focus.
• Gross Profit: This is an important indicator of your production efficiency. It helps in setting prices and targets for sales.
• Operating Profit: This shows how much income you are making after considering your operating expenses – This is EBITDA (Earnings before interest, tax, depreciation, and amortisation). This is an indicator that the investors are interested in.
• Net Profit: This is the bottom line that owners are most interested in as this is a measure of the income they have earned in the period.

Small businesses need to be focused on net profit or bottom line. You need to track and control your expenses to ensure that your bottom line is not suffering despite a good top-line (revenue) as it may mean that all your efforts are focused on increasing sales, but your expenses are not well-managed, leading to inefficiencies. You should look for trends in the performance of your business. Sudden spikes or dips in any line item should be investigated in greater detail. Gradual increase is normal on account of factors like inflation or salary increments.

ActionCOACH Business Coaching is a YouTube channel that gives business tips on business planning and profit improvement, amongst other advice. Watch the video below to know about how to read a Profit and Loss.

Stock records and stock controls

Stock, also called inventory, is critical to businesses; stock records help in maintaining control over the inventory. You can use these records to see which goods are selling better than others and helps you identify what the goods or materials you need to buy are and when. Accurate stock records are critical for small businesses.

Stock control is the process of ensuring that you have adequate stock to meet your customer demands without delay while at the same time you are keeping a check on costs without holding excessive stock.

There are four main types of stocks:

• Raw Materials
• Work in progress
• Finished goods
• Consumables

Costs associated with holding stocks can include:

• insurance costs
• shipping costs
• warehousing or storage costs
• financing or interest costs.

Key features of good stock records and strong stock controls for any business are that they:

• Prevent supply shortages
• Improve customer satisfaction
• Increase sales
• Improve employee satisfaction
• Reduce losses
• Improve cash flows
• Increase investor confidence

You must analyse your stock positions to find a balance between the costs of stockholding and the benefits from it. If you hold excessive stock, you increase your expenses and impact your cashflows. However, if you do not hold adequate stock, you may lose sales resulting in lost income and reduced customer and employee confidence. Holding an incorrect mix of the stock also can result in lost income, having to write down unused stock, especially if it is perishable in nature and poor customer service.

To have good stock control, you need to focus on the following:

Methods of managing stocks

Your stock control system or inventory control system must include all functions related to stocks i.e., purchasing, tracking, turnover, storage, shipping and re-ordering. There are two methods of managing your stocks:

• Manual Stock Management
  If you carry small amounts of stock, then this is suitable for you. You need to ensure you have a stock book to record all items that have been bought, sold, damaged, lost or returned. You need to track the value of each item as well as when your received or sent it out as well as the location for each item.
• System-Based Stock Management
  Manual stock management is not adequate when businesses grow. Then you need to implement an automated system that will help in improving productivity. These systems can support real-time inventory tracking, provide sales and shipping support, help in procurement of supplies and can integrate with your other systems like accounting systems.

Manage Cash Flows

Cash flow is critical for small businesses. It is the lifeline of any business. If you do not manage your cash flows, you are putting the short-term stability and long-term viability of your business at risk.

To manage your cash flows, you must:

• Understand the difference between profit and cash flow. You have a profitable business yet run into cash flow problems that can undermine your business stability.
• Know what your cash balance is. Understand it is different from your bank balance. You reconcile your bank balance and manage your cash balance.
• Have a projection of your cash flows for the coming months. Ideally, you should project your cash flows for a minimum of six to twelve months ahead.
• Use strategies and techniques to maximise your cash flows.
• Track your cash flows closely every month and adjust your forecasts.

If you are free from cash flow worries, you can focus your attention on running your business.

Systems Used to Monitor, Analyse and Report on Financial Performance

While you may be able to monitor, analyse and report on financial performance manually, it will be a cumbersome and error-prone process with you not gaining the advantages that financial analysis systems offer. These systems can aid in consolidating and comparing financial transactions and accounting entries. They can range from simpler excel based solutions to more advanced systems. You need to select the system you need, according to your budgets and the stage of business you are in.

These help in:

Monitoring

• They provide simple yet intuitive dashboards that graphically depict your KPIs along with the targets or benchmarks. They show the actual performance at any point in time against the benchmark.
• Some also provide an ability to send out alerts if thresholds defined by you have been breached.
• You can also set up who is the key person responsible as well as schedule review dates.

Analysing

Business growth and sustainability depend on accurate and timely analysis of its financial performance. By using financial analysis systems, it is easier and faster for a business to get detailed and accurate analytics. This helps in establishing the extent to which the business has met its financial goals. It also helps in making better and more informed decisions.

Some of the common types of financial performance analysis are:

Reporting

Financial analysis systems help in reporting as they ensure error-free reports that can be customised to the recipient's requirements are available. They can also help generate reports for financial compliance purposes.

Some popular systems used to monitor, analyse, and report on financial performance in Australia are given below.

• Sage
• Xero
• Intuit Quickbooks
• MYOB
• Reckon

Most software providers have learning resources available on their websites, which you can use to learn how to use their system.

Workplace Procedures for Financial Performance Management

As discussed earlier, comprehensive workplace procedures are established to ensure all activities help meet the organisational policies. Workplace financial procedures must comply with legislative and regulatory requirements to ensure that the business does not violate any provisions in monitoring, analysing, and reporting. They provide assurance that the business has executed key processes consistently across the business.

Workplace procedures must be followed for each component of managing financial performance, i.e., monitoring, analysing, and reporting.

Some sample workplace procedures for each component of financial performance management are given below:

Monitoring	Analysing	Reporting
Monitor expenses daily and seek explanation for any material variances from approved budget Review weekly ash flow forecast to ensure sufficient funds are available Monitor debtors monthly and prepare monthly aging debtors report	Analyse monthly expense trend by department Analyse monthly debtors aging report and present to management Analyse financial efficiency ratios monthly and present to management in quarterly review meeting	Manage the compliance with all state/territory ad federal tax laws Ensure lodgement of BAS, other returns with ATO. Ensure FBT declarations are reported within stipulated timeframe Coordinate the preparations of all financial statements, perform quality checks and finalise financial statements in publishable formats

Common workplace procedures for using digital technologies for monitoring, analysing, and reporting on financial performance may include those related to:

• Ensure data security
• Implement documented system access controls
• Implement password policy
• Implement data backup policy
• Ensure customer confidentiality
• Follow record retention

Data security is vital for businesses, as data is your virtual asset. You need to have workplace procedures for online security to protect your electronic data and systems. These procedures need to be aimed at protecting against the risk of hacking, viruses, and malware.

Businesses need to implement workplace procedures for access controls that define who has access to different menu options in their systems. Only your IT team should have access to the IT data and systems configurations. The workplace procedures should lay out whether the staff can connect to your network on their computing devices and, if yes, what are the procedural controls to protect the company data. You need to be aware of the risks in allowing employees to connect their portable devices to your business systems.

There should be clearly defined procedures for providing secure system access, authentication, and the use of passwords. Password policy and procedures ensure frequent changing of passwords and keeping them confidential.

Keeping data backups is a prudent risk mitigation strategy, and regulations may also require you to keep them. Detailed workplace procedures outlining the frequency of backup and their retention process need to be in place.

The Privacy Act has provisions to protect customer confidentiality. Your workplace procedures for using digital technology should be in place to avoid compromise of customer data.

Regulations define the retention period of critical financial statements and customer data. Workplace procedures should be in place to ensure compliance.

Marketing Strategies are strategies that define how the business will promote and sell its products or services in ways that will satisfy its customers. Operational Strategies are the strategies that define how the business will use its people, processes, and systems to support its business strategy. Financial, Marketing and Operational Strategies are all aimed at meeting your business objectives and goals. They all must be aligned to meet the overall business objectives.

While financial strategies have a direct impact on your financial goals, marketing and operational strategies also influence your financial goals. Hence, you need to track them regularly and monitor their impact on financial goals to monitor your business’s financial performance effectively.

Marketing Strategies and Impact on Financial Goals

Businesses implement various marketing strategies to meet their business goals of increasing revenue, profitability, and growth. These strategies help:

• Understand your customers
• Define space you will occupy in the market
• Know how you compare with competitors

Marketing strategies relate to the five Ps of marketing: Product, Price, Promotion, Place and People. Your marketing strategies will help you determine the products and services you will offer and at what pricing. They will also determine what messaging and the channels you will use.

While marketing strategies have a more direct correlation with sales and hence revenue of businesses, they also have a strong impact on profitability and return on investments. Given below are some examples to illustrate this:

• Your business’s marketing strategy of pricing your products lowest in the market may directly be contributing to your financial goals of increasing revenue. However, you may land up having extremely low margins, which impact your venture’s profitability.
• Similarly, your marketing campaign may create a great buzz in the market, but it may be expensive. You may need to evaluate whether your business can achieve a similar impact by a less costly campaign that would give you a better return on investments.
• Another example of how your marketing strategy can impact your financial performance is if you expand your customer segment, you can increase sales and revenues and thereby apportioning the fixed business costs of administration, human resources, and other central costs more efficiently. This, however, may not lead to desired results if the cost of entering new customer segments is excessively high.

Hence different marketing strategies may have differing impacts on financial goals, and you need to monitor them for their impact.

Operational Strategies and Impact on Financial Goals

Operational strategies help to implement effective systems for using resources, personnel, and processes to meet the business objectives. They help make decisions relating to the following:

1. Location
2. Processes
3. Technology
4. Capacity
5. Timing

Impact of operational strategies

Operational strategies determine how the business uses its resources to achieve its business goals. They can include strategies on resourcing, automation, and adoption of digital technologies, leasing vs purchase, capacity expansion and utilisation, distribution, amongst others.

Given below are some examples to illustrate the impact operational strategies can have on your financial goals:

• InputZ Pty Ltd, an application processing business, decided to automate its process to help reduce errors and increase staff productivity. However, despite a large investment in automation equipment, productivity was not improving significantly. On investigation, it became known that the staff were not using the machinery to its full capabilities. This was on account of weak training and resulted in sub-optimal cost savings. By addressing the training needs, they removed the inefficiencies and reaped the benefits of reduction in operating costs, thereby contributing to the financial goals.
• SparkZ Pty Ltd, a business involved in electronics sales from many retail outlets across a few cities, had a centralised warehouse in one city. The time it took to get replenishments from the central warehouse resulted in stockouts and lost sales. They improved their re-order level process and invested in regional warehouses to shorten the re-stocking time at their retail outlets. This change in their distribution strategy from a centralised model to a hub and spoke model resulted in increased sales and revenues.

Hence, like your marketing strategies, you must monitor your operational strategies for their impact on your financial goals.

Monitoring Marketing and Operational Strategies

You must have a continuing and systematic process to monitor the performance of your strategic plans and make refinements if needed. You should devise and implement a clear plan to monitor progress and identify and address any issues that may come up in the implementation of your strategies.

A monitoring process can be effective only if it:

• is designed in accordance with the nature of the business activity
• takes into consideration organisational culture
• is accepted by all relevant stakeholders.

Regular and systematic monitoring of strategies shows whether you are on track to meet your objectives. This allows you to evaluate your progress towards your measurable goals. You can quickly change your approach if monitoring shows that the strategies are not producing the desired outcomes. This results in the saving of precious time and money, giving your business a competitive edge. By monitoring your marketing and operational strategies to see the impact on financial performance, you maximise the effectiveness of your business plans. You will avoid unnecessary effort, eliminate distractions, and meet your objectives more efficiently.

Monitoring marketing strategies help you see if they are meeting the objective of return on the marketing plan and its overall profitability. Monitoring operational strategies also help to see if you are optimising your resources and improving productivity and efficiency, which lead to improved profitability and realisation of your financial goals.

These simple steps may help you review and evaluate the performance of your marketing and your operational strategies:

1. Select your KPI's that are aligned to your objectives
2. Set benchmarks or targets
3. Monitor and compare your performance against the targets or benchmarks
4. Analyse variance
5. Asses the reasons for the performance gaps
6. Take corrective action or make adjustments so you can meet benchmarks or targets

Financial ratios are the means to analyse the relationship between two or more components of your financial statements. One of the most effective means of monitoring your venture’s financial performance is to calculate financial ratios according to the Key Performance Indicators (KPIs) that you have selected based on your business objectives. You then need to evaluate them against your business and/or industry benchmarks. These benchmarks are standards against which you can compare the financial performance of your business.

Financial Ratios

Financial ratios are relationships determined from a company’s financial information and used for comparison purposes. You can use them to monitor the health of your business, identify potential problems in time and adjust your strategies or procedures to address the problems or the gaps. These comparative measures, usually expressed in percentage terms, convert financial information from the financial statements to a common format. This helps in comparison of your financial performance within various parts of your business, with other businesses or across the broader industry. Ratios can vary across industries, so it is essential to compare them with benchmark values. Ratios are an important tool to interpret financial statements like the balance sheet and the profit and loss statement.

Both internal users like owners, management and employees and external users like investors, lenders, creditors, and tax authorities use financial ratios for decision making and evaluation.

This section will explain the main types of ratios and how to calculate them. The types of benchmarks and how to use them to evaluate financial ratios will be covered in the next section.

The most common types of financial ratios are:

Profitability Ratios

Profitability ratios measure a business’s ability to generate income from utilising balance sheet assets, incurring operating costs, and deploying equity. It shows how effectively the business uses the capital received from shareholders and lenders. In addition to Net Profit Ratio and Return on Investment (ROI), some of the other most used profitability ratios are:

• Gross Profit Ratio
  This measures the profit generated from each $ of sales before considering indirect costs. It helps to measure whether the business is controlling its direct costs and how efficiently is it using its labour, raw material, and other supplies in its production process. It is also known as Gross Margin Ratio.
  Gross Profit Ratio=(Revenue-COGS)/(Revenue )
• Operating Margin
  Also known as Sales Margin or Return on Sales (ROS), it measures how much is the operating profit the business generating from each $ of sales. This helps assess where the operating margins are improving or declining. This measures the overall profitability of a business from its operations. It does not include the income from sources not directly related to the core business activities and nor does it consider tax and interest expenses. This ratio is looked at closely by investors and lenders as it shows whether the business will be able to cover its non-operating expenses.
  Operating Margin=(Earnings before Interest and Tax (EBIT))/Revenue
• Return on Equity (ROE)
  This is a financial metric that is used to assess the profitability of a business in relation to its equity. It measures the return on shareholder’s equity.
  ROE=(Net Profits after Tax)/(Shareholder' s Equity)

Liquidity Ratios

It shows how the business is placed to meet its short-term financial obligations. These determine the business’s ability to cover its short-term obligations and cash flows, whereas Solvency Ratios look at long-term obligations. These are useful for creditors and lenders who can get insights into the financial position of the business before extending credit to it. It is also useful for businesses to track as they need to ensure that they always have sufficient liquidity to be able to pay their bills, vendors, employees etc. Higher values indicate strong businesses as they indicate an ability to withstand periods of low cash flows. In addition to the Quick Ratio, liquidity ratios include:

• Current Ratio
  This simply looks at current assets and current liabilities. It determines the business’s ability to use its current assets, which include cash, inventories, and accounts receivables, to pay off its liabilities that are payable within the next 12 months. It measures the margin of safety the business has.
  Current Ratio=  (Current Assets)/(Current Liabilities)
• Cash Ratio
  This is the most conservative liquidity ratio and looks at the ability of a business to repay its current liabilities with cash and near-cash assets like marketable securities. This ratio is best compared with other businesses in the same industry.
  Cash Ratio=  (Cash+Cash Equivalent )/(Current Liabilities)

Solvency Ratios

Also known as Leverage Ratios shows how well the business is placed to meet its long-term financial obligations. It measures the ability of a business to pay off its liabilities in the long term. In addition, the following are some more commonly used leverage ratios:

• Debt Ratio
  This is the most fundamental solvency ratio as the ability of the business to repay them is the prime concern of all investors, lenders, and creditors. If this is low, then the company is not highly leveraged and is in a strong solvency position.
  Debt Ratio=  (Total Liabilities )/(Total Assets)
• Equity Ratio
  This ratio helps measure how well you have managed your debts and funded your asset requirements. A low ratio (generally less than 0.5) indicates a highly leveraged business that is considered risky. A high ratio, on the other hand, shows that you have funded your asset requirements effectively and without undue dependence on debt.
  Equity Ratio=  (Total Equity )/(Total Assets)
• Debt to Equity (D/E) Ratio
  This measures the degree to which the business has financed its operations through debt as opposed to using its own funds. A high ratio indicates considerable risk, especially in periods of economic downturns or when the business is going through a downward cycle. It makes the business more susceptible to risk, as it indicates a higher debt servicing obligation which may pose problems during downturns.
  D/E Ratio=  (Total Debt)/(Total Equity)
• Interest Coverage Ratio
  Also known as Times Interest Earned, this assesses the ability of the business to meet its outstanding debts. It represents how long can a business meet its interest liabilities with its current earnings. This is best measured over a period as it gives a clearer indication of where the business is headed.
  Interest Coverage Ratio=(Earnings before Interest and Tax (EBIT))/(Interest Expense)

Efficiency Ratios

Efficiency ratios measure how well a business is utilising its assets and resources. To evaluate these ratios, you need to compare them, both over a period and against the ratios of peer businesses. There are many efficiency ratios, in addition to the AR Turnover Ratio. Some popular ones are:

• Inventory Turnover Ratio
  This is the number of times a business manages to sell its stock of goods within a given period. It measures how well the business is managing its inventory.
  Inventory Turnover Ratio=  COGS/(Average Inventory)
• Assert Turnover Ratio
  This assesses a business’s ability to generate revenue from its assets.
  Asset Turnover Ratio=  Revenue/(Total Assets)

The Finance Storyteller is a YouTube channel that aims at making strategy, finance and leadership enjoyable and easier to understand. Watch the video below to know more about financial ratio analysis

Benchmarks for Financial Ratios

To evaluate your financial ratios, you need to compare them against benchmarks. These are the standards that will let you know how your business has fared. The benchmarks are:

• Internal
  • Comparison against a previous period
  • A business target that you wish to achieve
  • Comparison of different processes, units or geographies within the same business
  When using internal benchmarking to evaluate financial ratios, the financial ratios from different units, product lines, departments, programs, and geographies, which have shared ratios within the business, are compared. This helps in identifying best practices within different parts of your business that can be used for continual improvement. Ratios are also compared across periods to understand how the business is faring financially over the period. This helps in identifying trends that may be developing in the financial performance of your business.
• External
  • Industry benchmarks which you can obtain from Certified Public Accountant (CPA) Reports, independent industry reports, Australian Tax office.
  • Competitive benchmarks where you compare with the performance of your direct competitor.
  Key characteristics of external benchmarks are that when using them to evaluate financial ratios, the financial ratios of one business are compared to one or many other businesses in the same industry. This helps identify whether the business is doing better or worse than competitors or the industry as a whole. These examine both performance and practice.

Steps to use benchmarks

To use these benchmarks to evaluate your financial ratios, you may use the steps:

1. You may select either internal or external benchmarks or a combination of both for different ratios. You may select the best in class performance and identify your parity group.
2. These benchmarks must be communicated clearly to all stakeholders in advance, so the team is aware of what they are aiming to achieve.
3. Measure your performance and calculate the ratios that you have identified for your key performance indicators.
4. Analyse the variances and study the factors leading to these variances.
5. Based on the above, you should develop an action plan to address the variances. This may include process or procedural changes or modifications of your strategies themselves.

Benchmarking is crucial for strategic decision making. It helps identify which areas are performing well and in which areas, improvement or corrective action is required.

Activity 4 - True or False