Using financial indicators in the life of a company
In a business, financial indicators help management make well-based financial decisions. Because there are several types, they provide information that complement each other.
Common features of financial indicators
Source of data
The source of the data needed to calculate the financial ratios can be the following three:
- the balance sheet
- the income statement
- and a cash flow statement
Due to accounting principles, the three sources must contain authentic data. That is why they are suitable for preparing a decision.
The most important accounting principles for financial indicators
The principle of completeness
Changes in assets and liabilities should be fully recorded, including those that relate to the financial year but became known only between the balance sheet date and the balance sheet making date. This way you can be sure that all the information is at your disposal.
The principle of authenticity
The data must be realistic, identifiable and verifiable (eg by invoices, inventory, etc.). This way, you can prepare a decision that gives you the opportunity to make it happen.
Principle of consistency
Comparability is ensured in terms of the content and format of the report and the supporting accounting. This will make your job easier when you are curious about the various financial indicators over time.
The principle of comparison
Revenues and expenses relate to the period in which they are actually incurred economically. This greatly affects the accuracy and credibility of financial indicators, with far fewer distortions.
The precautionary principle
No result can be recognized if the financial realization of the revenue is uncertain. The effect of this can also be seen in the financial indicators, and later the money may flow, but with this you can get a result closer to reality, you take less risk.
Principle of gross settlement
Revenues and expenses are recorded separately in the income statement and balance sheet and should not be combined. In terms of financial ratios, you will find this particularly useful when it comes to revenue-based efficiency or cost-effectiveness.
Application of indicators
As these are, without exception, ratios, they cannot be applied on their own, taken out of their environment, but they can be an excellent basis for comparison.
This can be a comparison
- within the industry: how the company performs compared to other companies operating in a similar field
- comparing different periods of a given company: a trend can emerge by juxtaposing different periods
Whether we look at financial metrics within an industry or within a company, any of them may be able to predict problems.
Because they are ratios, they still have in common that they have no good or bad value. There is only one that is desirable or just desirable to achieve.
Types of financial indicators
Capital structure indicators
Capital structure indicators give an idea of whether the capital available to a company comes from its own or external sources.
- Business and financial risk
- Interest coverage: whether they can pay the interest
- The ability to multiply the equity provided by the owners
For efficiency indicators, the main question is how much you have used the tools at your disposal.
A high level of return on assets (ROA) indicates that you have used your corporate capacity efficiently, but it may also indicate that further asset expansion would be timely.
From the speed of inventory turnover, you can find out how many times the company has managed to sell its inventories in a year. On the one hand, a high turnover rate can also indicate efficient sales, but it can also mean a sub-optimal inventory.
Efficiency indicators also give you an opportunity to think over the financial planning.
The turnover rate of customers and the average collection period will show you how quickly you see money after the product is sold and how often your customers will buy from you again.
The same is calculated for suppliers (where you are the buyer) showing how many days the supplier will finance the product sold to you.
Comparing the two, you get the full operating cycle. That is, the period of time that elapses from the time you bought your inventory until the buyer not only bought it from you, but also paid it. You can also learn about the money cycle: that’s how long your money is in stock. You have already paid the supplier, you have not yet been paid by the buyer. The longer this period, the more capital intensive your business will be.
In the case of liquidity ratios, the question is whether the firm is able to pay its liabilities on time.
As stocks cannot always be monetized, it is necessary to use several liquidity ratios. These should be monitored frequently as they expire quickly.
Financial return indicators
In the case of return indicators, two main issues tend to arise:
- when plans for a later development are evaluated by the company’s management: the main question is whether to jump into it. Here, it is natural that the higher the return is desirable over the life expectancy.
- in the case of an existing activity, it may also decide to terminate the activity if its internal rate of return no longer reaches the desired level.
In these cases, financial management does nothing more than prepare for the most efficient use of capital, even over the years.
Profitability rates of return
In the case of profitability indicators, the question is how effectively the company generates its results.
You can use several results, such as:
- return on assets (ROA)
- return on equity (ROE)
- profit on sales (ROS) ,
If it affects you, you will calculate your dividend payout rate for this type.
Although too high a level of ROA and ROE looks good, it may indicate that more assets or capital need to be involved in the business to increase efficiency.
There is also no single interpretation option for ROS. The high value shows that the company made a big profit on the sales revenue, but it does not examine the issue of number of sales units. It is also necessary to find a healthy ratio when paying dividends. High value can be a good point in the eyes of shareholders, but it leaves so much less for development in the coming years.
Use of financial indicators
As you can see, the indicators also affect each other. You can use these values in several ways.
Poor liquidity sooner or later leads to bankruptcy. Accordingly, by analyzing financial ratios, you can find out what the potential sources of risk are and you can also find out what you can do to improve your liquidity. This can be eg:
- rotation speed improvement: then even a single day of improvement can show a significant improvement in results
- high indebtedness: interest has to be paid even when revenues fall, which degrades liquidity. In this case, prepayment, loan redemption, or debt settlement can be the solution.
- low profitability: typically caused by either high competition or a poor pricing model. Either reconsider your pricing or increase your turnover speed, or use any method, to retain your costumers.
In a future development plan, financial indicators will play a key role. After all, this decision will determine the possibilities of your company for many years to come. Here, be sure to use the indicators to think about the following:
- How much credit do you need, and what does your company able to pay?
- How does the post-implementation state affect your liquidity?
- When will the investment pay off and how will your profitability change as a result?
Expanding the circle of owners, preparing for the change of generation
In many cases, the topic of generation change only appears in the year in which the owner decides to retire, either voluntarily or by force. Of course, from the fact that your company is ready to hand it over to someone, you can even work for it for decades. To prepare for this, however, it is useful to know what you’re handing over to either the heirs or an executive who runs the company instead of the heir.
And expanding the number of owners means extra capital, so the company can grow faster. This can be either by involving a single big capitalist (who will help you with either your money or your money and expertise) or by issuing shares.
Whatever the main issue, you need to know that
- how efficiently the company operates,
- what are the sources of danger in your finances
- what profit owners (i.e. shareholders) can expect if they vote for your company
This point also prepares you to run your business in a completely professional way, not just because of your routine or habits, everything is going its own way.
- How do you coordinate the results of different financial indicators?
- How often do you look at trends?
- Which is the area where you see the most benefit from the indicators and where do you run into obstacles?
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