We’ve been blogging on our website for five years now. So it can be interesting to look back on what’s been popular with our clients. One surprise from our email stats was that lots of folk were interested in our plain-English take on financial accounts. Why’s that? And are you up for a part two?
Our guess on the first question is that most of us don’t study accounting at school. So we carry around gaps in our knowledge and want to know a bit more. At the same time, we all have an image in our heads of thick, dull accounting textbooks. No-one wants to go there! Instead, it’s handy to pick up some basics using things like blogs and videos.
That earlier blog focused on the financial or ‘statutory’ accounts that limited companies must send to all shareholders and to Companies House. These are the balance sheet and profit and loss account. Sole traders and partnerships must also produce them of course – although there are fewer rules around this.
Let’s imagine the team at Merlin has just produced your financial accounts. Do you just breathe a sigh of relief that Companies House won’t come knocking for another year? Or do you sit down to think about what you can learn? This is where your management accounts could come in.
Management accounts – what are they?
You can think of them as your ‘secret’ reporting as they’re typically for your eyes only. You need them to run your business properly, but they’re not required by law. There are no rules that say what these accounts must look like – you choose what format will do the best job. They might include ratios, cashflow forecasts, KPIs, debtor reports – typically all coming from different systems (including paper ones).
Choosing your focus and getting on top of these reports is a good discipline. Ultimately, it will allow you to get closer to your goals – from more sales or profits to getting your working hours down and planning retirement.
Start with three simple ratios
The best place to start is often with some simple analysis of the financial accounts you already have. We are going to explain three simple ratios that accountants and business coaches look for.
As some of us can just remember from school, a ratio tells us about a relationship. In this case, how many times one number contains another. The ones we’re going to look at are the:
- Current ratio
- Return on equity
- Debt-to-equity ratio
Current ratio – or do you have enough cash?
For this ratio, you’ll need your company’s balance sheet. Now find the total for current assets – this includes cash, accounts receivable, and stock. Divide this number by your liabilities, which may include wages owed, short-term debt and money owed to suppliers.
If this gives you a number higher than one, that’s good. You have enough money to cover your immediate needs, or at least the ability to find it quickly. If the number is less than one, you are short of money to cover your urgent expenses.
An example
Let’s say a company has £120k in current assets and £80k in current liabilities. So its current ratio = £120k ÷ £80k = 1.5. It has (or can release) £1.50 for every £1 of current liabilities. That tells us it’s in a good position to meet its short-term obligations.
Did you know?
A high current ratio isn’t always a good thing. If it’s much higher than average for your sector, it could mean you’re holding too much cash or inventory instead of investing for growth. A retailer with lots of unsold stock might have a high current ratio but still face difficulties if those products don’t sell.
Return on equity – what’s the profit level from the owners’ investment?
This ratio tells us how good your company is at making money using the funds provided by its owners (shareholders). ROE is the net profit divided by the average shareholders’ equity.
This one is a favourite metric for the legendary investor Warren Buffet. He looks for companies that can maintain a high ROE over many years, not just a high figure once. Or, in plain English: “Time is the friend of the wonderful business.”
To work out your ROE, find the net profit from your profit and loss account. This shows total earnings after all expenses, taxes, and interest. From the balance sheet, get the shareholders’ equity. This is what’s left of the assets of the company after deducting liabilities. To get the average, add the equity at the beginning and end of the period covered and divide by two.
An ROE of 15% or higher is often seen as good. But ask us about this, because there is so much variation across different sectors.
Debt-to-equity – are you borrowing at a sensible level?
This looks at how much of a company’s money has come from loans compared to the input from its owners. You work it out by adding both the short- and long-term debt from the balance sheet. Take the total debt and divide it by the shareholders’ equity, which you have from the ROE calculations.
A low ratio is like owing a little on a small personal loan. It’s nothing to worry about. But a high ratio might show that you’re carrying a bit more risk than you feel comfortable with.
Of course, some industries would struggle to exist without high debt. Real estate developers, utilities, and infrastructure firms routinely carry large amounts of debt because their assets generate predictable cashflows over decades.
In summary:
- Try playing with these ratios to make more sense of your financial accounts
- A good current ratio means you can pay your way in the short-term
- Return on equity shows us how efficiently you are handling the money that shareholders have contributed
- The debt-to-equity ratio measures how much debt a business is carrying compared to the amount invested by its owners
How Merlin can help
To find out more about our approach to financial and management accounts, please contact us. Our clients say that it’s useful to have a numerate friend prodding their thinking, especially one who understands the issues. If you’re not already a client, please get in touch here. You’ll find us a good fit if you’re looking for an accountant as an investment – rather than just a cost.
