I’m going to produce a report evaluating the relative significance of solvency and profitability ratios in identifying serious problems of business performance.
Ratio analysis is the single most important technique of financial analysis in which quantities are converted into ratios for meaningful comparisons, with past ratios and ratios of other firms in the same or different industries. Ratio analysis determines trends and exposes strengths or weaknesses of a firm.
I agree that solvency and profitability ratios can be used to identify serious problems in a business’s financial performance. However, businesses must be aware that profitability and solvency ratios should be used with caution as these ratios have limitations. For instance, solvency and profitability ratios alone won’t tell you the full story of the business’s performance. Therefore, the business should be aware that there may be other factors internally and externally which could contribute to the business performing poorly.
There are many reasons why the use of ratio analysis will benefit a business. Firstly ratio analysis simplifies the financial statements and helps in comparing companies of different size with each other. This can be beneficial to a business because they can gain ideas for their own business to help improve their performance. Also you can see if your business is performing successfully or is performing poorly in relative to the figures of another business. In addition, ratio analysis helps in trend analysis which involves comparing a single company over a period of time. And lastly, it can highlight important information in simple form quickly; businesses can explore their business performance by just looking at few numbers instead of reading the whole financial statement.
The first ratio is the solvency ratio. This ratio will measure the ability of the business to settle its debts in the short term. The solvency ratio is very helpful for a business. This is because this ratio allows managers to see the businesses’ cash position and can therefore see if there are any causes for concern and find solutions before it becomes a major issue. Also its good because from this ratio a business will clearly see if they are in the state to pay off their short-term liabilities when they fall due, if they can’t, they will need to find ways to be able to, as it may lead them into financial danger. They can do this by raising sales and reducing costs such as raw materials and making some staff redundant. However, if the business occurs a problem when calculating the ratios, and they are unable to pay their debts on time, it will be hard to know how to solve the issue. This is because the ratio does not tell the business what factors are playing a part in the business not able to pay their debts.
Therefore, it may be hard for the business to find ways to ensure they will be able to pay their debts on time if they are unsure of what factor is causing the issue. A business will make use of the current and acid test ratio to see the performance of the business. If the current ratio is less than 1 then they are in trouble and means the business has more liabilities than current assets. Furthermore, if the acid test ratio is closer to 0 it means the business is not in a position to pay their debts without selling their stock. These ratios can clearly show the business if they can pay their debts with or without selling their stock and can plan a solution if they can’t.
The second ratio is profitability. These ratios assess the amount of gross or net profit made by the business in relation to the business’s turnover or the assets or capital available; this will be good for a business to use as they can see how much money they are making, and can see if there are any causes for concerns. An advantage of the profitability ratios is that they are simple to calculate and understand. This therefore means it’s very easy for the business to assess their ability to generate earnings compared to its expenses and other relevant costs incurred during a specific period of time.
A disadvantage is once again, from this ratio you cannot see what factors are effecting the ratio. Therefore, if the business are making losses they won’t know exactly what the cause which makes finding the solution harder. The business will make use of gross profit margin and net profit margin. If the business made loses it will make the ratio negative which means they have performed poorly. This is good as it highlights any problems and they can quickly find solutions for it. In addition they will use the return on capital employed; businesses aim for 20-30% however if the percentage is very small it suggests the business hasn’t made a profit therefore they will be able to see this and work towards a larger profit.
There are other internal and external factors that can affect the businesses performance. External factors are factors that happen outside the business. For instance the first external factor is the state of the economy. For instance, if the country is in a recession it will mean that people don’t have a large disposable income to pay for wanted items. Therefore, there will not be a big demand on goods and services meaning that a business will have low sales and will make losses. Another external factor that can affect the businesses performance is their competitors. This can be a problem if their competitors are selling similar products and there will be not be a big demand for your products which will have a negative impact on their ratios. The last external factor is seasonal demand. Some products are only seasonal products therefore, when its low season the business performance won’t be very good as there are low sales and this will effect profits and ratios.
Internal factors are factors that happen in the business. For example, loss of key staff can have a major impact on the businesses performance. Key staff are vital for success of the business as they help run the business. If they leave it will be hard to maintain the success. Similarly, if the business have inexperience management it will lead to many problems. If they are inexperience they won’t be able to drive the company forward and motivate the staff therefore the business won’t perform efficiently. Another internal factor is the product life cycle. All products have a life cycle and they will start to decline. Therefore it’s important for the business to consider the product life cycle and what stage it is in.
This is because they may need to rebrand or remodel the product. Lastly, a factor that can impact the business performance is if machinery breaks down. This is because the business will need machinery to manufacture their products and if it’s broken they won’t be able to. This will mean they have no products to sell which will lead them to poor sales and losses. In addition, if their machinery is broken they will need to repair or replace it which will cost money. This will have a negative effect on their ratios as they will have an increase in costs.
In conclusion, I agree that solvency and profitability ratios are helpful to businesses. This is because they can highlight any problems that the business may be facing; such as being unable to settle their short term debts or if they are not making a significant profit. Although these ratios are very helpful, businesses need to be aware of other factors such as the economy, competitors, life cycle and loss of key staff.