Your organisation’s finances provide a reasonably objective way of assessing how well you are doing. Financial analysis can help you to see how your organisation has improved over time, compare it to your competitors and / or enable you to set targets for future improvements.
Most financial analysis techniques use ratios or percentages as their basis, dividing one financial number by another. Profit margin is a common example: an operating profit margin of 15% (or 0.15 in terms of a ratio) is calculated by dividing an organisation’s operating profit by its revenue. The 15% result suggests that every £1.00 of sales generates £0.15 of operating profit. Remember that these measures are useless in and of themselves; financial ratios / percentages are only useful if you can compare them either to the past and / or to other (comparable) organisations.
Financial analysis generally addresses two key questions:
We provide here an introduction to a few of the performance and financial status ratios / percentages that are often used as part of financial analysis. Depending on the nature of your social enterprise, some will be more or less relevant. Also, don’t view financial analysis as a ‘set science’ – there may be measurements / calculations that are both relevant and unique to your business that you could use. And finally, remember that your social enterprise is not just about the finances; your social and environmental impacts are at least as important to measure and track, as discussed elsewhere in this toolkit.
Note: the following sections assume a minimum level of understanding of the main components of an income statement (aka profit and loss account, P&L), balance sheet and cash-flow statement. These financial statements were introduced at a broad level earlier in this theme of the toolkit; however detailed construction and components of the various financial statements are beyond the scope of this toolkit.
1. Operating Profit Margin = Operating Profit / Revenue
The most common measurement of performance is the profit margin. The profit margin indicates how much profit has been generated for every £1 of revenue made by the organisation. It is a measure of how ‘efficiently’ you are earning each £1 of revenue. The measurement presented above focuses on operating profit; but depending on the nature of your organisation it may also be worth measuring gross profit margin and / or net profit margin.
2. Return on Assets = Revenue / Fixed Assets
This ratio tells you how well your assets (plant and machinery, office equipment and systems, vehicles, etc.) are working for you. It tells you how much revenue has been generated for each £1 invested these assets. It is most relevant in organisations that are ‘asset-driven,’ for example a social enterprise that manufactures products. It will be less relevant for those that focus on service delivery and for whom performance is driven by staff rather than the way in which assets are utilised.
3. Stock management = Stock Value / Cost of Goods Sold
If your organisation is a products-based business then stock management (i.e. your policy in relation to stock ordering frequency and volumes) is likely to be an important aspect of effective operations. Whilst you will always want to have enough stock to hand to fulfil customer orders, holding stock brings ties up cash and in addition may lead to additional warehousing costs for your organisation. The stock management ratio above gives you an indication of the levels of the stock you keep relative how much stock you are selling on to your customers. If your average stock level is £10,000 over the course of a year, during which time you have sold stock with a value of £120,000 to your customers, then the ratio 1/12 indicates that you are generally holding 1 month’s worth of stock.
4. Ratios involving P&L cost items e.g. Marketing Expenditure / Revenue
Finally here, we mention a ‘catch-all’ in relation other cost items that you will see on your organisation’s income statement / profit and loss account. Ratios can be used to track and evaluate how effectively you are spending money in different areas of your business in order to generate revenue. The example given provides a metric for assessing the effectiveness of your marketing spend. An equivalent ratio / percentage could be calculated for other areas of cost such as Staff Costs, Distribution and Logistics Costs, Admin and Overhead Costs, etc.
The point made earlier is important to reiterate here: one-off calculations such as those set out above are of little value. The purpose of financial analysis is to compare how you are currently doing to how you did in the past, how you want to improve in the future and / or how you compare to your peers and competitors.
The previous section was about performance; the other major branch of financial analysis considers your organisation’s overall financial position, i.e. how well placed are you to meet your financial obligations in the future?
Before discussing the 4 key financial status ratios, it is important to make a note here about working capital. Working capital is the day to day ‘financial engine’ of an organisation. It is a measure of all of the assets of an organisation that are relatively easy to turn into cash (usually stock, debtors and cash at the bank or in hand, collectively known as current assets) minus liabilities of the organisation that will need to be paid off soon (i.e. within 1 year – these are the creditors or current liabilities an organisation). Working capital gives you a good sense of the availability of cash for an organisation in the near term (sometimes called its liquidity). A healthy working capital enables an organisation to avoid a cash crunch which can be fatal for an organisation, however well it might be doing in terms of generating sales and having impact.
1. Current Ratio = Current Assets / Current Liabilities
The current ratio indicates to what extent short term (current) assets are adequate to settle short term (current) liabilities. A current ratio of less than 1 would indicate that current assets do not fully cover current liabilities; this may be a cause for concern unless the nature of your business has a strong daily cash flow (e.g. retail). Remember that the current ratio can also be too high, indicating that you are tying up to much money in short term assets, some of which may be incurring a financing cost (e.g. warehousing for stock; opportunity cost of a high level of debtors).
2. Acid Test Ratio = (Debtors+Cash) / Current Liabilities
The acid test ratio is an even stricter test of liquidity. Instead of looking at total current assets, the acid test ratio only considers those current assets that are ‘very liquid’ – i.e. debtors and cash. Stock is not considered when calculating the acid test ratio, since this may take several months to turn into cash.
Note that there is no ‘right’ number to target for either the current or the acid test ratios; however, different sectors will use their working capital in different ways, leading for example to these ratios being markedly different for a successful manufacturing organisation versus a retail organisation. This is one area where it may be worth researching financial information of competitors and/ or industry averages if available.
3. Debt Ratio = Total Debt / (Total Debt + Equity Invested + Retained Profits / Reserves)
The debt ratio indicates the amount of money that has been invested in the organisation by debt investors compared to the total amount invested in the organisation. A higher ratio means a greater exposure to debt (aka higher gearing for the organisation). This is an important measurement since, of course, debt investment brings with it a cost – interest charges. Any new investor will be particularly interested in your current level of debt and will use the debt ratio as a simple indicator of your position.
4. Interest Cover = Operating Profit / Interest Payable on Debt
As indicated, debt brings with it interest. Interest is paid out of operating profits (i.e. revenues less operating costs). The interest cover ratio considers how many times the organisation’s operating profit can repay your interest charges. A ratio of 1 would mean that your operating profit just covers your interest charge, leaving you with a profit / surplus of nil. A ratio of less than 1 will mean you end up with a loss / deficit and indicate problems with your financing structure. Organisations will usually be aiming to have an interest cover ratio of at least 3, and preferably much higher.
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