Must know for HR....Basic understanding of Business Finance - Part 6

People are lucky and unlucky not according to what they get absolutely, but according to the ratio between what they get and what they have been led to expect. Samuel Butler

Ratio is a term which was introduced in academies quite early in our life however most of us in HR are not well versed with its significance in business environment. These ratios can be analyzed to identify the company's strengths and weaknesses and useful insights can be gained through the process. Typically, ratios are excellent devices for uncovering clues about a company's financial condition. Ratios tell us where to focus our attention and to ask relevant questions. We never want to depend of just one ratio to draw a conclusion, the ratios are complementary and one ratio can be used to confirm a suspicion raised by another ratio's value. It is only after looking at a variety of different ratios that a picture of the company's financial condition begins to form. in a nutshell, Ratio is primarily used to understand the health of the business. Ratios compare one thing to another, this establishes a
relationship or co-relation.

If we want to know what percent of sales the net earnings are we would need to divide the amount of sales into the amount of net profit for eg. if the sales are Rs. 900,000/- and the net
profit is Rs.15,300/-, the percentage is 18000/900000 = 2%.

Now let’s look at ratio of assets to sales. If the sales are 900,000 and the assets are 400,000, the assets generated sales of 900,000/400,000 is 2.25 times the assets value – there is a turnover of 2.25 times. If the top number is smaller than the bottom number the ratio will be percentage, if the top number is larger than the bottom then ratio will be expressed as “times” Ratios help us to understand how these numbers work together. For example, a company's current ratio tracks the relationship between assets and liabilities. 

Following ratios over time will help you to understand the momentum in the business. Are assets increasing vis a vis liabilities?  There are multiple common ratios that can be used to measure the business, while most of these ratios shall be used in manufacturing industry however, may not be very relevant in service industry.

There are 3 types of key Ratios, let’s understand them in detail and terms used within each of them :


1. Liquidity Ratio : They measure amount of cash available to cover expenses both current and long term. In other words, It measures the amount of cash or investments that can be converted to cash in order to pay expenses, bills or other obligations that become due. These ratios are especially important for keeping a business alive. 

The current ratio measures the ability of the company to meet short term obligations. Current ratio = Current assets/current liabilities. A low current ratio may indicate a lack of capital to pay off debt and to take advantage of discounts. On the other hand a high current ratio does not necessarily mean a company is in good shape, it could mean that its cash is not put to the best use. It is generally accepted standard that current assets should be 2 times or 200% of 
the current liabilities.

The turnover of Cash Ratio measures the adequacy of the company’s working capital which is required to pay bills and finance sales. It is called working capital because it is the amount necessary to operate your business on daily basis. The working capital is the current assets minus current liabilities. Turnover of cash ratio = Net sales/working capital. A low turnover of cash ratio is that you have funds tied up in the short term low yielding assets. A high ratio could mean an inability to pay your bills. It is generally accepted standard that sales should be 5 or 6 times of working capital.

The debt to net worth ratio measures total debt coverage. It expresses the relationship between the capital contributed by the creditors and that contributed by the share holders. Debt to net worth ratio = Total debt/Net worth (share holder’s equity). A low debt to net worth would indicate that a company could borrow money easily. It could also mean that the company is too conservative, on the other hand a high ratio indicates that most of the risk in the business is assumed by the creditors. Obtaining money from outside sources such as banks would be
more difficult.

Analysts generally recommends that current liabilities to net worth should not exceed 80% and long term debt should not exceed net worth by 50%.