Finance: Objectives, Records and Ratios
What you must understand
Finance has two broad roles: strategic (setting financial objectives that support the business plan) and operational (day-to-day recording and reporting). Know the objectives: profitability, growth, efficiency, liquidity, solvency and return on investment.
Understand financial records: balance sheet (assets, liabilities, owner's equity - the accounting equation Assets = Liabilities + Equity), income statement (revenue, expenses, profit), and cash flow statements. Distinguish cash flow from profit - a profitable business can still fail from poor liquidity.
Learn the key ratios:
- Liquidity: current ratio (current assets ÷ current liabilities); acceptable around 2:1. Gearing (total liabilities ÷ total equity).
- Profitability: gross profit ratio (gross profit ÷ sales); net profit ratio (net profit ÷ sales); return on equity (net profit ÷ equity).
- Efficiency: expense ratio, accounts receivable turnover.
- Comparative ratios: vertical (same year, common-size), horizontal (across years), trend analysis.
Also study working capital management, debt vs equity finance, and financial institutions (banks, superannuation, ASX, unit trusts, insurance companies).
Traps in questions
- Mixing up solvency (ability to meet long-term debts) with liquidity (short-term obligations).
- Treating a high current ratio as always good - too high may indicate idle cash or excess inventory.
- Confusing gross profit (revenue minus cost of goods sold) with net profit (after all expenses).
- Forgetting that ratios are only meaningful compared with prior years, industry benchmarks or competitors.
Worked example
Current assets $150,000; current liabilities $100,000; inventory $40,000. Current ratio = 1.5:1 - below the 2:1 benchmark. Possible causes: high short-term debt or slow receivables. Recommendations: negotiate longer supplier terms, tighten receivables collection, or reduce inventory - each improves liquidity but may affect supplier relationships or sales.
Rule of thumb: state the ratio, compare it to benchmark, explain the cause, then recommend with a trade-off.