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Engineer Your Finances: Accounting Ratios – The Safety Factors of Your Business

December 13, 2023 Wanga Mbasa No Comments

Introduction

In the previous edition of Engineer Your Finances we looked at 3 Quick Ways for Engineers to Understand Finance & Accounting, in this edition we balance things out by looking at accounting ratios also known as financial ratios. Financial ratios play a crucial role in assessing the health and performance of a firm. Engineers, accustomed to precision, can leverage these ratios to gain valuable insights into various aspects of financial management. Just as engineers understand the importance of precise measurements in constructing a stable structure, financial ratios, akin to fractions, provide a nuanced understanding of a firm’s financial landscape. Fractions, with their numerator and denominator, represent the delicate balance that engineers seek in their designs. Similarly, financial ratios, with their distinctive components, unveil the proportional health of a company.The value of a financial ratio, much like a critical value in engineering, can indicate whether a business is in a favorable position. For example, in engineering, the safety factor ratio (SF) is used to determine the structural integrity of a design. If SF is less than 1, it signals a potential failure. Similarly, financial ratios below certain thresholds may suggest financial risks or inefficiencies in a business.

Profitability Ratios

Gross Profit Margin: The gross profit margin is calculated using the formula: (Sales – Cost of Goods Sold) / Sales. It assesses the profitability of a firm’s core activities, excluding fixed costs.

Operating Profit Margin or Return on Sales (ROS): This ratio is calculated as Earnings before Interest and Taxes (EBIT) / Sales. It measures the income a firm generates after deducting costs and expenses from total revenue.

Net Profit Margin: Calculated as Net Profits after taxes / Sales, this ratio provides a measure of overall profitability. It is also referred to as Profit Margin, Net Margin, or Net Profit Ratio.

Return on Investment (ROI ratio or Du Pont ratio): ROI is calculated as Net Income / Total Assets. It indicates the ratio of money gained or lost on an investment relative to the amount invested.

Liquidity Ratios

Current Ratio: Current Assets / Current Liabilities. This ratio assesses a firm’s ability to pay its debts over the next 12 months by comparing current assets to current liabilities.

Acid-Test Ratio (Quick Ratio): (Current Assets – Inventories) / Current Liabilities. This ratio measures a company’s ability to use quick assets to settle current liabilities immediately.

Activity Ratios

Activity ratios focus on how quickly a firm converts non-cash assets into cash assets:

Average Collection Period: Accounts Receivable / (Annual Credit Sales / 360 days).

Average Payment Period: Accounts Payable / (Annual Credit Purchases / 360 days).

Inventory Turnover Ratio: Cost of Goods Sold / Average Inventory.

Inventory Conversion Ratio: Inventory Conversion to Cash Period (Days) = 360 days / Inventory Turnover.

Debt Ratios

Debt ratios measure a firm’s ability to repay long-term debt and its financial leverage:

Debt Ratio: Total Liabilities / Total Assets.

Debt to Equity Ratio: (Long-term Debt + Value of Leases) / Stockholders’ Equity.

Long-term Debt/Total Asset (LD/TA) Ratio: Long-term Debt / Total Assets.

Times Interest-Earned Ratio: Earnings before Interest and Taxes (EBIT) / Annual Interest Expense.

Overall Coverage Ratio: Cash Inflows / (Lease Expenses + Interest Charges + Debt Repayment / (1-t) + Preferred Dividend / (1-t)).

Conclusion

Financial ratios serve as powerful tools for engineers-turned-entrepreneurs to navigate the complex landscape of business finance. These ratios, reminiscent of engineering precision, provide a systematic approach to evaluating a company’s financial health. Just as engineers meticulously calculate safety factors for structural stability, entrepreneurs can use financial ratios to gauge the stability and prosperity of their ventures.

As we wrap up our exploration of financial ratios, remember that each ratio is a piece of the larger puzzle. Just as a well-designed structure requires a careful balance of elements, a successful business demands a holistic understanding of its financial metrics. So, engineer your finances with the same precision you apply to your projects, and build a resilient and prosperous business foundation.

Thank you for joining us in this edition of Engineer Your Finances. Stay tuned for more insights into merging the worlds of engineering and finance, creating a roadmap for your entrepreneurial journey.