THREE MUST KNOW FINANCIAL RATIOS FOR ENTREPRENEURS

An entrepreneur can learn to improve his / her business in a healthy manner by understanding the following three ratios.

1. CURRENT RATIO (Liquidity),
2. TOL / TNW (Gearing), and
3. PAT / NS % (Profitability)

of these three, we are discussing current ratio in this blog.

Firstly, an entrepreneur should see the balance sheet and understand that there are two components compiled by the accountant / auditor.

Balance Sheet

Profit & Loss Account

Balance Sheet is nothing but the snap shot of the Company’s Assets / Liabilities on a particular day. This exercise is normally carried out as at 31^st March (closing data) every year. Certain companies follow calendar year closing and the data will be compiled on 31^st December every year.

P & L is the summary of all Income Expenses occurred over a period, say from 1^st April to 31^st March. This data will be divided as direct / indirect, etc. as per accounting standards stipulated by the Accounting like CA institute bodies. As non financial business owners it is important to know the numbers i.e. top line / bottom line, that can be analyzed for a day, month, quarter or a year.

1. Appearance of a Balance Sheet can be summed up in 3/6 major heads for easy understanding

LIABILITY		ASSETS
Current Liability		Current Assets
Long Term Liability		Miscellaneous Assets
Share + Capital + Reserve		Fixed Assets

Total

 

Each component of Assets or Liabilities could be grouped in the above 6 boxes by suitably grouping. Assuming X has obtained a OD / Working Capital Loan. This classification should be figured under Current Liabilities (CL). The stocks debtors should be figured in Current Assets (CA).

 

 

2. Appearance of the P & L Account

Particulars	Amount	Particulars	Amount
To Opening Stock		By Sales Account
To Purchase Account		By Closing Stock
To Direct Expenses
- Wages
- Electricity
To Gross Profit
Total
To Indirect Expenses		By Gross Profit
- Salary		By Indirect Income
- Bank Interest		- Interest on deposits
- Depreciation		- Sale of assets
- Travelling		- Non operating income
- Telephone
- Audit fees
- Service Tax
- Nett Profit
Total

 

By understanding each component of expenses a business owner/entrepreneur can identify how to classify the expenses / income with greater awareness.

Case I: Current Ratio

            This is the most important ratio for a business man to understand. By tabulating the current assets and current liabilities from the balance sheet and then applying the formula the ratio is obtained.

Current Liabilities		Current Assets
OD		Stocks
Short Term Payable		Debtors
Creditors
Current Liabilities	100	Current Assets	133

 

Current Assets / Current Liabilities = 133/100=1.33

The liquidity is comfortable in the instant case. The day to day operation will be smooth for this company.

Case II:

Current Liabilities		Current Assets
OD		Stocks
Short Term Payable		Debtors
Creditors
Current Liabilities	100	Current Assets	100

5

In this company the CA = CL and the day to day activity is just being managed. It is witnessing a scrap through daily. The OD / CC will be in brim position. Mild excess drawing and interest payment delay is likely to happen very soon.

Current Liabilities		Current Assets
OD		Stocks
Short Term Payable		Debtors
Creditors
Current Liabilities	100	Current Assets	90

 

Ratio: 90/100=0.9

• This Company has diverted the assets / source to long term uses like non productive Assets / Building / Machinery.
• This Company is likely to face liquidity crisis (Already the symptoms started).
• The company should bring in long term capital / sources in order to improve the ratio.

Correct understanding of Current ratio

For the sake of formula, current ratio = CA/CL. But we should understand a concept called liquid surplus. This is the difference between Current Asset - Current Liabilities. The difference comes only by long term sources like capital. This could be understood as under.

Current Liabilities	100	Current Assets	100
LTL	200	Stocks	100
Capital	233	Debtors	300
Total	533	Total	533

The above timely shows the extent of 33 has been funded from long term sources.

The lessons learnt for Business Owners / MSME entrepreneurs

1. Never divert the money intended for business for other purposes.
2. The bank OD / CC to be used only for the purposes of building Current Assets.
3. The liquid surplus (CA-CL) has to be built from long term sources like capital / retaining the profit to increase the Current Assets.
4. The Business Owner/ Entrepreneur should educate the staff / accountant to work out this ratio periodically and provide him / her feedback.
5. There are many business ventures which have suffered due to inadequate working capital and thus it is very important to address the current ratio.
6. A well managed liquidity position is a good tonic for the owner to stay always healthy.