As part of our 'Bookkeeping in Practice' series, ICB's Director of Learning Peter Stewart turns his attention to ratios.
When going through the ICB qualification, you’ll have had a module introducing you to some common accounting ratios. It’s useful to know these as they are part of the ‘language’ of accounts and it is important that you don’t feel left out in conversations using that language.
I’ve lately become aware of software packages that claim to provide a health check of a set of accounts using “artificial intelligence” and have to say I was really impressed. Not with the software as much as the marketing that has gone into making the product sound so cutting edge.
I hope that I can convince you to use your own “very real intelligence” to help clients to understand the financial health of their business and to offer insight into how they might be able to improve profitability or cash flow.
A ratio is ‘just’ a numerical way of describing the relationship between two aspects of a business. As you know, if you invest money into any type of venture, you hope to get that money back in the future with a little extra on top. If the money’s going into a bank, you expect to receive interest. If the money goes into a business, you hope that it is used to generate income from profits.
Just as a bank will tell you the interest rate you’re earning (i.e. income divided by the amount invested), a business investment can be measured by (income divided by the amount invested) which we’ve called “Return on Capital Employed”. Now, don’t go thinking that an interest rate and a figure for ROCE are directly comparable; as you know, the figures for “Return” and “Capital Employed” are affected by how we’re told to account for income, expenditure and historical costs – so it’s an ‘accounting measure’. However, it’s very broadly similar and ROCE can be particularly useful if it’s measured in comparison to either (i) previous years in the same business or (ii) ROCE figures generated in similar businesses.
There is no “correct” or “ideal” figure for a ratio like ROCE. Much depends on the nature of the business. In a retail business, capital is required for premises and for stock of goods for sale. In a service business, such as a mobile hairdresser, the capital investment will be much lower, so the ROCE percentage will be much higher. However, in any type of business, if there were an increase in capital invested, you would expect a proportionate increase in income and “returns”, so the ROCE should stay roughly the same.
Similarly, you might all know how to calculate a “Current Ratio” is or it’s cousin, the “Quick Ratio” but it’s only meaningful in certain circumstances. For instance, the Quick Ratio is often thought to refer to a business’s liquidity. It compares the value of ‘liquid’ assets (i.e. cash and debtors) to the value of current liabilities. In effect, it’s measuring whether a business could meet all its short-term obligations if they suddenly became due.
What are the chances, though, that all of your creditors demanded immediate payment; your bank demanded full repayment of your overdraft, and HMRC demanded immediate payment of all amounts due? It would be a highly unusual set of events that led to that happening; extreme events that you would hope the business owner was aware of.
Some text books would have you believe that a Quick Ratio of less than 1.0 should be a cause for concern as it indicates an inability to pay debts as they fall due. However, consider the case of Tesco plc: their Quick Ratio is always in the region of 0.4 and no one would suggest that Tesco is in any financial danger. The low ratio is partly due to the fact that a supermarket business does not tend to sell on credit terms. Furthermore, Tesco manages its cash flow extremely carefully and maintains tight control over its suppliers/creditors.
You’ve also learned how to calculate ratios such as ‘debtor days’. This type of ratio firstly measures what the average daily sales (on credit) have been and then divides the debtor balance by that amount to give a measure telling you that the debtor balance is equivalent to, say, 65 days’ worth of credit sales.
Now this is a useful health check if your business has been selling on credit with a stipulation that invoices should be settled within 30 days. There’s a quick calculation telling you that that’s not happening. However, your bookkeeping software should be generating an aged debtors report for you. Scrutiny of that report will tell you in more detail who’s invoices are overdue and by how much, allowing you to select individual customers with whom you need to have a conversation.
In conclusion, my point is that a bookkeeper already has all this critical information at their fingertips for each of their clients and by knowing where to look, should be able to generate relevant insight to offer to the client about the financial health of their business without the need to turn to “AI”, which hasn’t (yet) learned how to get under the skin of the business.
