Being able to understand and interpret a set of company accounts is useful, particularly if you’re considering investing in that company. These steps will help you confidently approach a set of accounts and give you some tips on how to examine the financial health of the business in which you’re interested:
Look at the gearing of a company.
In other words, look at the level of debt to equity at which a company is operating. If a company is highly geared, it may not be able to service its debts properly in times of poor cash flow. As an investor, you should be looking at the debt:equity ratio of the company.
Debt:Equity ratio = long term liabilities / owner’s equity
For example, say that a company has debt of £6000 and equity of £15,900. The ratio would equate to 0.38 (6000/15900). This means that the company has three times more equity to debt. Lenders like to see lots of equity supporting the company’s debt, because they know that the money they loan out will be much safer.
Remember that maintaining an adequate cash flow is what keeps a company in business, so being able to investigate the liquidity of a company is very important.
These are the two key ratios with which you should be familiar, in order to be comfortable determining the level of liquidity within a business:
Current ratio = current assets / current liabilities
The current ratio tests the company’s short-term solvency – in other words, the ability to pay off its short-term liabilities. The ratio indicates whether the amount of cash in the bank (or in hand), plus the immediate cash receipts due from debtors, and future sales of stock, will be enough to pay the short-term liabilities that the company has. Businesses are expected to have a minimum ratio of 2 – in other words, twice as many current assets to current liabilities.
Acid-test ratio = (Cash at bank/in hand + debtors) / current liabilities
The acid-test ratio is a much more severe test of the liquidity of a company. The acid test excludes stock and concentrates on the most liquid assets – that is, those that can convert the quickest into cash. This is sometimes known as the ‘quick ratio’.
The general rule is that the acid-test ratio should be at least 1.0, which means that the liquid assets equal current liabilities.
Current Liabilities £7,975
Acid-test ratio = £8,500 / £7,975 = 1.06
The Return on Assets ratio (ROA) is an indicator of how profitable a business is in relation to its assets.
You calculate this ratio as follows:
ROA = Net profit / Total assets
For example, suppose your business has a net profit of £4,500 and it has a total asset value of £18,875. You would show the ROA ratio as follows:
= £4,500 / £40,050
This means that the company made 11.2 per cent on each pound of assets it holds.
ROA can vary, depending on what kind of industry you’re in. Technology industries are more likely to have a lower ROA as their total asset value is much higher in proportion to a service industry which may not have many assets at all.