Knowing the person through Financial Ratios

 

Let me begin with some assumptions – I am assuming a small business which may be in any formal form like proprietary, partnership or even closely held private limited company and most important - there is only one principal decision maker (PDM).

I will quote actual ratios (suitably rounded up or down) of one of my clients to make the example easy to understand. (How to calculate the mentioned ratios is not part of this writeup)

The client is into manufacturing of MDF furniture (Customized and standard both). Standard furniture is sold to furniture retailers on credit. Customized furniture is normally without credit, barring few exceptions.

Ratio

Clients Values

Current ratio

1.5 (Outstanding CC included)

Average Receivable period

135 Days

Average Payable Period

45 Days

Average Inventory Holding Period

100 Days

Turnover

15Lakhs

Cost of Goods Sold

75% of Turnover

Cash Credit

60% of Working Capital

If we look at the current ratio, which ideally should be 1.33 or more, apparently the ratios suggest that the business will not have short term liquidity problem. Looking deeper, beyond numbers, we will be able to find problems. The Receivable period is alarmingly high on the other hand Payable period is significantly lower. Inventory holding is also significantly higher.

All these areas indicate towards one weakness and that is “the principal decision maker has poor negotiation skills”. He/she is unable to negotiate even for terms which are close to industry average. He/she is not able to figure out the potential loss due to relaxed terms of credit to customers. Higher Inventory holding suggest that suppliers easily lure the owner by discount offers, there may be other reasons as well in most cases. All the ratios though out of sync with industry average does not raise any obvious red flags but reveal a weakness only on looking beyond numbers. The findings based on financial ratios mentioned above were substantiated using other techniques like interviewing the owner and key staff members, DMIT & Graphology of PDM. Getting the other tests is not necessary, but it will always add value and substantiate the findings, thereby giving opportunity to provide most suitable solution which can be outside the purview of Financial Management.

Suggestion given: 

1. To appoint a person who is good negotiator to deal with terms of credit with customers & suppliers. 

2. To setup an objective inventory management system and not to deviate more than 10% from the systems output.

Both these suggestions were implemented by the client, the results were visible after about 18 months, not only ratios improved but the overall profitability increased, though some furniture retailers discontinued thereby impacting the turnover but the net profit in absolute terms increased due to timely recovery, thereby savings in interest cost.

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