Use of Ratios in Decision Making
Of the most typical tasks of Management Accounting is to understand relationships between different activities and report it in a manner which will be useful for decision making. One of the ways that this is achieved is through Ratio Analysis. From a management accounting perspective ratio in a way are ready-made since its sources are data from financial statements, data that are primarily prepared by and for the financial accounting branch. The fact that management accounting has no fixed structure it can afford to make use of any data no matter where it comes from and it gets hold of.
Ratio itself is a relationship between two or more numbers. For business purposes ratios are relationships calculated from the firm’s financial information, primarily financial statements. No matter how credible these ratios may be, in terms of sources used and complex calculations, on their own are meaningless. In order to make any use they have to be compared with some other ratio of the same type, but either from a similar organisation or same industry. They can also be used to draw comparisons with other periods of the same entity. In reality users of ratios very often get the correct ratio, number, but the wrong benchmark. It is one of the key management questions of the type: What business are we in? Comparing ratios of a large supermarket store with a local vegetable producer selling on the local market is meaningless. Both of them may be selling vegetables, but the scale of operations, capital resources and probably brand make them two different entities operationally and incomparable to one another.
Nevertheless, for a small business owner ratio can serve as a valuable tool with which they can measure and over time observe their progress towards a set goal, regarding a competitor or industry average. Just maintaining an interest in tracking ratios, it can prove a powerful tool in identifying trends in early stages. The so-called ‘Operational Ratios’ help firm’s owner drill down and understand what aspects of the firm are running smoothly and where more attention is needed. Let us not forget that there is a large number of ratios, all of them with their importance according to the firm and user’s needs. They range from a simple measurement of COGS to Sales measurement and all of the way to EPS and P/E ratio. In purpose I am not going to explain in detail these abbreviations since this article is supposes to be a broad explanation of few ratios and their use in a day to day management of a small firm. For this purpose, it would pointless if we were to explain in detail relationship between, for example, turnover and share price.
Operational Ratios
From my experience with a number of small firm’s owners I have come to understand that one of the most challenging tasks is to balance business activities and cash flow. Separate from any industry specification one task is common to any profit making business; acquiring of supplies, undergoing an in-house value adding process, selling the finished product to third parties. At each end of this process is cash; financing purchases at the beginning and collecting cash from customers for the sale made. The length of this process is known as Cash Conversion Cycle (CCC).
Faster and cheaper this process is conducted the higher the profits for the business. Therefore, an owner or decision making person must know the specifics of this process and at which part the process is lagging behind. This analysis revolves around three ratios:
- Days Sales Outstanding
- Days Inventory Outstanding
- Days Payables Outstanding
For specifics of each of them I would invite you to read more and also draw your attention that there may a variety of names used and methods in calculation. Nevertheless, the task of each of them is to measure the days taking to convert into cash outflow or inflow.
Example
For illustration purposes let us think of a following example. A company produces a new type of pumps. The business sells the pump to wholesalers and retailers and has an annual turnover of $300,000. The following data relate to each pump produced.
The company wishes to expand the sales volume of the new pump. It believes that offering a longer credit period can achieve this. The business’s average receivables collection period is currently 30 days. It is considering three options in an attempt to increase sales revenue. These are as follows:
To enable the business to decide on the best option to adopt, it must weigh the benefits of the options against their respective costs. The benefits arising will be represented by the increase in profit from the sale of additional units. From the cost data supplied we can see that the contribution (that is, selling price ($60) less variable costs ($30)) is $30 per every unit sold, that is, 50 per cent of the selling price. So, whatever increase there may be in sales revenue, the additional contributions will be half of that figure. The increase in contribution under each option will therefore be:
The increase in trade receivables under each option will be as follows:
In reality any increase in receivables that results from each option in one way or another would mean additional finance costs to the business. If we are to estimate the cost of finance for the business at 15%, net increase in the business’s profit arising from the projected change would be:
At the end of this example I would like to bring to attention the risks that are associated with granting and extending credit deadlines. For any customer or application for credit a thorough due diligence should take place and only after set criteria are met credit is to be approved.
Summary
Example above may look too obvious. However, I have seen many businesses that at certain point they had uninvested cash in their bank balance. From the point of leisurely lifestyle, the idea of owing money to others may not sound attractive. Actually, we have all come across people who pride themselves of not owing money to anyone. However, business is there to speculate and take risks by making the most of resources available in the market. An important resource is ability to borrow either directly or indirectly. Recalling the CCC ratio it is very important that business collects cash before its supplies are due for payment. In fact, it should not stop here, it should aim for a negative CCC, which would require a detailed management of stock levels as well as product placement. New technology advancement has made possible a lot, one of them Just In Time (JIT) operations. Meantime business owners should not feel afraid taking on new risks and exploit all that market has to offer.