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GETTING THE FINANCIALS RIGHT

Do you know how your bank determines how well your business is going? Having an understanding of the financial factors involved will give you a head start, should you need to apply for finance.

You would have to be living on another planet to have not realised that the banks and other financial institutions are tightening up their credit policies and procedures. This has led to a lot of pest managers having to provide more information about their financials, not only when applying for more credit but also for completing their annual review with the bank.

So what key performance indicators are the credit analysts at the bank using to determine how well your business is going?

Firstly, given that they are endeavouring to paint a picture of the business, the balance sheet is the chief resource used. The balance sheet is a snapshot of the business taken at the close of business on 30th June, the end of the tax year.

To demonstrate the bank’s KPIs and general targets, we will use a simple case study – below is a balance sheet and a profit and loss statement for the fictitious company XYZ Pest Control, showing information for the financial year July 2016 to June 2017.

Balance Sheet for XYZ Pest Control
30th June 2017
Current Assets
Cash on deposit $20,000
Trade debtors $40,000
Stock on hand $5,000
Total $65,000
Non-Current Assets
Vehicles & equipment $100,000
Total Assets                $165,000
 
Current Liabilities
Bank overdraft $50,000
Trade creditors $10,000
Total liabilities                        $60,000
 
NET ASSETS
(Assets – Liabilities)
$105,000

(Net assets are also know as shareholders’ equity or net worth)

Profit & Loss Statement
30th June 2017
Sales $300,000
Cost of Sales $60,000
Gross Profit $240,000
Expenses $220,000
NET PROFIT $20,000

Using the information from these tables, I will give examples of each of the standard ratios that the banks use to calculate the profitability of a business. It should be noted that financial institutions may utilise additional calculations to the ones shown here.

Calculating your working capital

This ratio is a test of trading liquidity. You can work out your ‘current ratio’ or ’working capital ratio’ using this formula:

Current assets ÷ by current liabilities

$65,000 ÷ $60,000 = 1.08 : 1

The rule of thumb from financiers is that your working capital ratio should be between 1.5:1 to 2:1. So in this example, XYZ Pest Control has insufficient working capital.

Calculating your acid test ratio

You can work out your liquid, quick asset or ‘acid test’ ratio (all names for the same thing) using this formula:

(Current assets – current stock) ÷ by (total liabilities – bank overdraft)

($65,000 – $5,000) ÷ by ($60,000 – $50,000)

$60,000 ÷ $10,000 = 6.00 : 1

This ratio differs from the current ratio in that slow-moving assets are deleted and the bank overdraft is usually secured against assets of the business by a deed of charge or personal assets. A commonly accepted standard is 1:1. Ratios greater than 1:1 are generally a good sign, but less than 1:1 indicates that there are not enough liquid assets to pay current liabilities and this will be an issue should it remain so for any length of time.

Calculating your gearing ratio

The purpose of this ratio is to compare the shareholders’ investment with the liabilities to bank and creditors. It follows this formula:

Total shareholders’ funds (AKA net assets) ÷ by total liabilities

$105,000 ÷ $60,000 = 1.75 : 1

From a lender’s point of view, they will want this ratio above or close to 1:1, but in reality the ratio may well be determined by the pest manager’s attitude towards risk and the business’s day to day trading.

It should be noted that the further ratio drops below 1:1, the more the bank considers the pest management business to be a risk, as the business is considered ‘highly geared’ and susceptible to interest rate rises. The business may break the rules of its bank loan, meaning the bank would have to take action.

Calculating your return on investment

This ratio joins the profit and loss statement (activity over the year) to the snapshot of the business: the balance sheet on the last day of the financial year. It reveals how efficient the business is in generating profit against the shareholders’ investment, and is calculated this way:

Net profit ÷ by shareholders’ funds (AKA net assets) x 100

$20,000 ÷ by $105,000 x 100 = 19.04%

The aim is for the percentage to be as high as possible, however this needs to be balanced against the gearing ratio. Whilst the return on investment percentage is excellent (because the shareholders have minimal funds invested in the business and are relying on external funds) this exposes the business to downturns and increasing interest rates. I personally use a minimum target of 18% for a pest management operation.

Calculating your breakeven point

This ratio is crucial to financiers in reviewing a pest management business’s financial performance and viability for the future. It measures the percentage of sales you can afford to lose before you cannot cover your expenses and is calculated like this:

Net profit divided by gross profit x 100

$20,000 ÷ $240,000 x 100 = 8.3%

At 8.3% XYZ Pest Control is at high risk of several factors: a downturn in the economy; increasing pressure from existing competitors; and pressure from new entrants in the marketplace. My target generally is 20%.

Other ratios calculated by financiers include the gross profit margin, debtor days, and days creditors outstanding, which have been written about in previous issue of the magazine.

The ratios in this article will be used by financiers to look into your business and from this they paint a picture – make sure that before they paint the picture, you already know what it will look like!

Peter Cox, Peter M Cox & Associates

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