2. All ratios reduced to four golden rules
3. Solvency: How heavy is the company loaded with debt?
4. Liquidity: Can I pay the bills?
5. Profitability: How much does the invested money in this company generate for me?
1. The three overviews of Financial Management
- The Balance sheet that is a snapshot of all the assets of the company on the left (asset) side and on the right (Equity and Liabilities) side the ownership distribution.
- The Profit and Loss Statement which shows the value of the activity performed (turnover) in relation to the used recourses (costs) within a period.
- And thirdly, the Cash Flow Statement, which is a periodical overview of all cash flows in and out of the company.
If you have difficulty understanding the article below, first read the articles concerning the financial statements. This will contribute a lot to your financial insight.
1.1 The consistency of the three overviews
I often read articles on the internet and am surprised by the total lack of financial logic of the writers. More specifically, the lack of understanding the interrelationship between overviews and their goals. The year starts and ends with a Balance Sheet. The difference in cash on both Balance Sheets is explained into detail by the Cash Flow Statement and the difference in profit is explained via the Profit and Loss Statement. Every ratio is dropped in space without any background or link to the objective. As a result, overviews and ratios seem randomly chosen and impossible to remember or apply. However, all ratios are all based on just a hand full of golden rules.
The discipline of Financial Management can be subdivided into different areas of expertise.
- Financial Accounting focuses on the creation of the three financial overviews.
- Within Management Accounting we use predominantly the P&L and Balance Sheet that are made to make decisions and to monitor the profitability of the activities of the company.
The two golden rules of Management Accounting are:
Maximize Profit and
Or in a slightly different way, that might be easier to understand: Make sure that people at your party get the largest possible piece of cake. How can you accomplish this? Option one: bake a big cake or option two: kick people out of the party. In financial terms: Make as much profit as possible (cake) and do so with the help of the least possible capital (people). Because everybody that invests capital in the firm expects a return.
- Within Corporate Finance we look forward into the future. We use the Cash Flow Statement and the Balance Sheet specifically for possible investments.
The two golden objectives of Corporate Finance are:
Invest with Minimal Risk and
Invest with the shortest possible Time.
In other words, I want to invest my money but preferably back tomorrow and without risk.
If you stick these four starting points with a post-it on the bottom of your screen, you can explain all the objectives and ratios of your company. Some examples: improving current activities by selling more (= more profit) lower costs (= more profit) lower stocks (= less capital), customers who pay me faster (= less capital) or suppliers that I pay later (= less capital). With new activities, the time frame of the investment and the risks are equally important.
3. Solvency: How heavy is the company loaded with debt?
Solvency is the collective term to reflect whether the company has been able to realize much profits with the use of capital. This requires further explanation:
The Balance an overview of the value of my assets with a distribution to whom it belongs. To calculate the solvency, different formulas can be applied. However, these all relate to the proportions in the balance sheet. As a reminder: On the left side of the balance sheet are all the items with which the company works. This is what we call the assets and stands for the accounting value of the company. On the right side it is described who will receive how much of that value. You should also keep in mind that Liability providers (lenders / bank) receive interest and that this is deducted from the profit. The Equity Providers (owners of the company) are entitled to the net profit of the company. This can be paid to the owners in the form of a dividend or "saved" as a profit from the past.
- A good solvency = little debt = low liabilities
- Bad solvency = a lot of debt = high liabilities
Solvency relates to the relationship between the value of the company and which part of it is due to the equity providers in relation to the Liability providers. Or in other words: "How heavy is the company loaded with debt?" The best thing of course is not to have a debt at all. That is the case for companies and also for your home, preferably without a mortgage. If you do not have enough money to set up a new factory, go to the bank. If this factory delivers enough you can repay the loan. If you are performing badly, you will have to take out an extra loan to pay normal things like salaries. This shifts the ratio of Equity and Liabilities. The loss is deducted from Shareholders' equity and the liabilities rise by getting an extra loan. Solvency thus shows how heavily the company is burdened with debt. Heavily debt-loaded companies (= with poor solvency) have not made much profit in the past and are therefore at greater risk for the loan provider.
To calculate the solvency you can use different formulas.
- (Assets / Liabilities) * 100% = 2300/1300 * 100% = 177%
- (Equity and Liabilities / Liabilities) * 100% = 2300/1300 * 100% = 177%
The assets are equal to the Equity plus the Liabilities, after all what I have (assets) belongs to someone (Equity and Liabilities)
- (Equity / Liabilities) * 100% = 1000/1300 * 100% = 77%
It is no coincidence that this is exactly 100% less than Solvency 1. After all, the difference between the total Assets and the total Equity is always the total Liabilities. Look at the Balance Sheet!
- (Equity / Assets) * 100% = 1000/2300 * 100% = 43%
Debt Ratio (= Gearing)
- (Liabilities / Equity and Liabilities) * 100% = 1300/2300 * 100% = 57%
Solvency is: How much debt do I have? Improving solvency can therefore be done in two ways:
- Generate profits and with that pay off loans
- Work with less capital and repay the loans with the released capital.
Uhhhhh ……. Do you recognize these two objectives ....... yes exactly the two golden rules of Management Accounting. That is why you hear so much about solvency!
The very existence of leasing companies is based on this principle. Why does a company want to lease the cars or machines? Because they are not part of the Balance Sheet. And if they are not on the Balance Sheet, I do not have to raise the capital to buy them .......
Very bland to write but good solvency is better than that of your competitors. Why? If you work in a company that has to deal with a shrinking market, there is little innovation in the products and even bad economic conditions ....... you cannot compare it with the first company that is next door. In addition, company habits and culture are also important aspects.
What is important when evaluating solvency? How much capital is provided by debt in relation to the Equity. Of course it does not matter which of the solvency measures you use as long as you know which one it is and you compare the correct with each other. If a company has no debt, it is easier to get new loans at lower interest rates. If a company has a great deal of debt, it is getting closer to bankruptcy and it therefore has an increasingly poor solvency.
What is considered poor solvency, is determined by the industry of the company. The companies in the automotive industry all have very poor solvency if you compare that with the average production company. Is that bad? No, it is normal for that industry. In the assessment you therefore look in particular at the competitors and of course the development over time. Does the company develop in the right direction (can I redeem) or not (and I have to borrow).
4. Liquidity: Can I pay the bills?
The solvency relates to the long-term profitability of the capital, the liquidity on the other hand relates to the short-term payment ability.
It is crucial for every company to ensure that bills can be paid. After all, no company has ever gone bankrupt because they made losses. All companies that go bankrupt will do so because they are no longer able to pay and postpone payment or eventually apply for bankruptcy. Liquidity is therefore about the short term: "Can I pay my bills?". If you foresee that you have a period when your money is short, you can go to the bank for a loan. If your solvency is good, you get a loan easily, if not…..it is difficult!
But one fact is clear when it comes to applying for a loan: Do it far in advance! Banks determine your risk profile. If you need the cash tomorrow, you are in a poor situation. Why? Because you have no control over your company. After all, you have not seen the cash deficit coming and can therefore not assess whether you are able to pay it back .......
The Balance Sheet is the overview from which I can read: "Can I pay my bills?" To calculate the Liquidity, we normally take one moment in time. In doing so, we check whether what we have to pay is in high enough to what we have plus that what we will receive. We normally use two formulas to calculate this:
- (current assets / current liabilities) = 700/500 = 1.4
- (current assets / short-term debt) = 700/500 = 1.4
To calculate the Current Ratio we include the value of the stock as money that I will receive. I do not have to explain to any entrepreneur that it is not very easy to turn your stock into cash. After all, I first have to find a customer who wants to purchase and pay me. In the value cycle, you can see that the inventory is another step that is certainly difficult to achieve for companies in heavy weather. That is why we use a second criterion where we leave the stock out of consideration.
- ((current assets - inventory) / current liabilities) = 500/500 = 1
- ((current assets - stock) / short-term debt) = 500/500 = 1
The above calculations of the Current and Quick Ratio can be made at any point in time to assess whether you can meet your payment obligations. We call this the static liquidity (at one moment). In addition, you can also view for a longer period whether the cash inflow is sufficient in relation to the outflow. We do this by making a prognosis in time of developments and therefore we name this the dynamic liquidity.
Liquidity is a measure to determine whether I can pay my bills. Of course I do not want to get into trouble by having too little cash available at any point in time. That is why I would like a Quick ratio of more than 1. Opinions differ on whether a too high Quick ratio exists. Anyway it is always a sign of strength if you have a lot of money available.
5. Profitability: How much does the invested money in this company generate for me?
As described above, Solvency shows how heavily the company is burdened with debt. The Liquidity examines whether I can pay my bills. The last of the three most commonly used criteria concerns the Profitability. This shows how much revenue I can realize with the money that has been put into the company.
The aim of the profitability is to see how much the cash that an investor has invested in a company yields. We can view this from two perspectives:
The accounting return is based on the values of all assets in the accounts as recorded on the Balance Sheet and is based on the seven accounting principles. Earn profit with the capital applied or share a cake at a party with those attending. The company has two types of capital providers. These are the equity providers, the owners of the firm and the liability providers whom will loan you cash. The owners are entitled to the net profit, this is the result of the activities carried out by the company in the period. The loan providers receive interest as compensation for the capital provided. Read my articles about the Profit and Loss Statement and the Balance Sheet if the following explanation is not clear to you.
When we talk about yield, we are talking about a percentage. You know this yourself from your mortgage on which you also have to pay a percentage per year to the bank, namely your interest rate. The owners and lenders expect a payment on the money they have invested for each year. To calculate the accounting return, we look at three variants:
- Net profit relative to equity,
- Interest relative to the liabilities or
- net profit plus the interest relative to the Total Assets.
Why do I want to know this? As a lender I always have the opportunity to withdraw my money and put it in another company. Here again the two golden starting points of any investment apply. If I invest my money in company A I get it back at time ....... and in the meantime I run a risk of ...... I compare this for all my options / companies. I put my money in companies where I have the highest profit relative to the risk that I am willing to take.
In addition to the accounting return, there is also the possibility to determine a market return. We assume the actual realized returns from the perspective of the capital provider and not from the company.
You buy a share for € 15 on 1st January. During the year the price of the share fluctuates on the stock exchange and on 31st December the value is € 16 at the moment you decide to sell the share. During the year, a dividend of € 1.50 per share was also paid out. What is your return in this example? You have invested € 15 all year and have therefore realized € 1.5 dividend and € 1 profit from sales. In total you have managed to get € 2.5 per € 15. Your return is thus 2.5 / 15 * 100% = 16.7%.
- Profitability Shareholders' equity = Net Profit / (average equity) * 100%
- Profitability Liabilities = Interest / (average liabilities) * 100%
- Profitability Total Capital = (Net Profit + Interest) / (Average total assets) * 100%
- Profitability Equity = (Received Dividend + Sales price share - Purchase price share) / Purchase price share * 100%
- Profitability Liabilities = (Interest received + Sale price Loan - Purchase price Loan) / Purchase price Loan * 100%
The market return on debt may seem strange at first sight. However, I can sell claims that I have on my customers to a third party. They will collect the loan. The price for which I sell the receivables in the market is usually lower than the nominal value of the loan.
An example to explain further. Imagine I am a dentist. I treat my patients and like to do that but I dislike the accounting part of my profession. That is why I decided to sell the rights to another party. I make invoices for a value of € 2,500 per day. I also know that work has to be done to collect the money and I know that some of my patients do not pay. That is why I sell the receivables with a nominal value of € 2,500 to an administration office for € 2,200. The difference of € 300 is a compensation for the work of collecting, the risk of not getting paid and the time difference between paying to me and getting money from the (insurance of the) patient. As such, receivables or loans have a market value, just like shares.
What is the leverage? Leverage is created by a shift between the Equity and Liabilities. What happens: Suppose a company has € 75,000 (75%) Equity and € 25,000 (25%) Liabilities and makes a profit before interest of € 8,000. The mortgage has been closed at a rate of 5%. Therefore, the interest payment is € 25,000 * 0.05 = € 1,250. The equity providers therefore receive € 8,000 - 1,250 = € 6,750 which represents 9%.
The finance director of the company goes to the bank to increase the mortgage to € 50,000 and uses the capital to repay the equity providers. The bank has agreed to a new interest rate of 6%. The following year the company once again makes a profit of € 8,000 before interest. The interest payment is € 50,000 * 0.06 = € 3000. The equity providers therefore receive € 8,000 - 3,000 = € 5,000, which is 10%.
Is it wise to bring about the leverage effect?
By putting more liabilities into the company, the return of the Equity! Butttttttt it conflicts with one of the golden rules of Financial Management. Namely: I invest with minimal risk. What happens in reality. The bank has provided more debt. The solvency of the company has therefore deteriorated. That is why the bank now requires 6% of the company instead of the old 5%. After all, the risk of bankruptcy for the bank has increased. The equity providers receive higher returns. They go from 9% to 10%. But be careful! The equity providers also have a higher risk in the new situation. Before they are entitled to Net Profit, an interest of € 3,000 must be paid. In the past this was only € 1,250 and the chance that something remained for them was much larger.
In short, this reflects one of the rules of Modigliani and Miller: The risk of the company determines how much return I as a lender demand. Where I get my money (and how I distribute the risk over different groups) is irrelevant. This rule also applies within companies. If I have a project of which the outcome is uncertain (for example R&D), this should yield a higher return on investment than if I have a low risk project (for example service optimization).
Profitability has everything to do with the proceeds realized by capital providers on the cash they have invested. There are two groups of capital providers within companies. Equity providers who run a lot of risk because they are in the back of the line when distributing the profits and liability providers who run less risk because they always get paid except when the company goes bankrupt.
You can calculate the profitability from the perspective of the company (the accounting profitability) and from the investor (the market profitability). In the long term these two are connected to each other. Due to the whims of the stock market, this is certainly not the case every year.
The leverage only makes sense if you tend to forget risk.
In this article I introduced the four golden goals of Financial Management for the first time:
- Make as much profit as possible => Profit maximization
- Do this with as little money as possible => Capital minimization
- Invest with as little risk as possible => Risk minimization
- Receive the money back from the investment as quickly as possible. => Time minimization
We assess companies from the outside on the basis of three types of criteria:
- Solvency: How heavy is the company loaded with debt?
- Liquidity: Can I pay my bills?
- Profitability: What does the invested cash bring?
Would you like to receive my free book Financial Management unravelled?
Fill in the form below and mention the description "Book Financial Management Unravelled". You will receive the book and my article: "The eight most common financial mistakes by managers".