All about ratios

A company’s accounts, balance sheet and profit and loss account can be a mystery to all but the accountants. To demystify these documents, let’s consider in turn what each does, and why it pays to have some understanding of what they may be used for.

Accounts relate to a set period, and while it is common to analyse them for this period, it is possible to make more frequent analyses, to aid the financial control of a business.

Amounts from the accounts can be compared using a technique called ratio analysis. The results tell potential shareholders, investors or fund providers whether the business is financially sound, stable and a vehicle that will produce value and returns, either through dividends or profit sharing.

The managers or trading partners can also use ratio analysis to assess the firm’s liquidity and productivity.

Firms will always try to present accounts in the most favourable light, so exercise caution when undertaking checks. Ratio analysis is a clumsy tool. Accounts, even though they must be produced in accordance with conventions and regulations, can be manipulated to disguise weaknesses.

Comparing data in a volatile, inflationary environment is risky. To mitigate the risk, analysis must be made of several sets of accounts, with an eye on trading conditions.

An important issue to check is whether a business has sufficient money to finance its short-term commitments, or whether there is a likelihood that, although profitable, the business will trade itself into insolvency.

This is commonly known as the liquidity ratio or acid test.

To achieve this, it is important to understand what each statement represents and to appreciate the type of things that may be in them.

The balance sheet

The balance sheet provides a picture, at a precise moment in time, of the assets and liabilities of a business. On the one side, in financial terms, the possessions of a business are displayed. On the other is displayed the provider of funds.

A firm will always attempt to present its accounts in the most favourable light, so exercise caution when undertaking checks

For instance, if a £10 000 car is bought using a bank loan of £10 000, one side of the balance sheet will contain the value of the car and the other side the value of the loan. The balance sheet must always balance. The car is viewed as an asset. The loan you are liable to repay, and so it is known as a liability.

The assets are shown on the right of the balance sheet, the liabilities on the left. It is the culmination of this dual aspect of record-keeping that has given rise to the common term ‘double-entry book-keeping’.

The assets and liabilities are further subdivided into fixed assets and current assets, and debts and equity.

On the liabilities side, debt is the monetary expression of the liabilities to suppliers who have not yet been paid, or the discharge of bank loans.

Equity is where persons have contributed finance to the business as an investment, but may also contain profit from previous years that has not been paid out in dividends.

At this point, it is worth looking at a company’s set of accounts to familiarise yourself with the headings.

Profit and loss account

Profit or loss is the sum of cash that is left after deducting the cost of sales from the value of those sales.

Given that we are now familiar with the duality principle, it will come as no surprise that one side of the accounts, the left-hand side, will disclose the expenses, and the right, the income.

But this ignores the cash transactions that appear in the balance sheet as, for example, when a company receives a loan from a bank, or expenses that fall outside the balance sheet period, or the cost of goods or services not yet sold.

But for the purposes of establishing a business’ liquidity, that is all you need to know – until next month.