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Financial ratios as an evaluation instrument of business quality in small and medium-sized enterprises

Katarina ŽagerFaculty of Economics & Business - University of Zagreb, Croatia

Ivana Mamić SačerFaculty of Economics & Business - University of Zagreb, Croatia

Nikolina DečmanFaculty of Economics & Business - University of Zagreb, Croatia

Abstract

Small and medium-sized enterprises have been recognized as a separate but very important economic discipline. SMEs prepare financial statements usually for external users, primarily to meet tax regulations and legislations. Internal reports, on the other hand, are under-represented or non-existent. This means that accounting information is insufficiently used in decision-making processes and management of small and medium-sized enterprises. The more intensive explanation of internal reports could intensify financial position and business performance. They are one of the prerequisites for long-term growth and development of enterprises. In that sense, the importance of financial statement analysis needs to be stressed. Principal tools and techniques of financial s ta tement ana lys is are wel l recognized. However, financ ia l s ta tement analysis is certainly not confined to horizontal and vertical analysis. Financial ratio analysis is of extreme importance. They are widely accepted in business practice of large companies, primarily because of the simplicity of its calculation and use. Bearing that in mind, the subject matter and objective of this paper is to indicate the trends and dynamics of some of the most important financial ratios of financial position and business performance of SMEs in the Republic of Croatia. Based on the obtained results, the quality of business performance will be evaluated for this important economic discipline.

Keywords: financial ratios, business quality, small and medium-sized enterprises

Introduction

Small and medium-sized enterprises (SMEs) are considered to be a separate but very important economic discipline. SMEs are a very important part of any country’s economy due to their numerosity. That confirms the fact that there are over 20 million SMEs in the European Union; that is 99,8% of the total number of active entities (European Commission, 2008). The same situation is recognized in Asia and Pacific, where SMEs make up 97% of the total number of entities. In the USA that percentage is even higher 99,70%. (Klikovac, 2006).

Small and medium-sized enterprises are frequently confronted with the numerous market and statutory challenges. According to the survey results (IFAC, 2011.) 29,4% SMEs find the economic uncertainty as the highest business challenge. It is followed by statutory burdens (27,1%), difficult fund access (16,7) etc. As a result of unpredictable business environment, business management has become more complex, especially for smaller enterprises. However, despite those challenges, SMEs have some advantages unlike

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those of the large ones. They can timely and easily suit any changes and be more flexible answering the challenges than the once of more complex organisational structure. Professional literature offers numerous and interesting advice on improving financial condition and business performance.19 Quality information is the foundation of all business decision making processes.

Accounting information system is an important source of substantial information that can bring about the improvement of a company’s business operations. Basic tasks of accounting are primarily gathering and processing primarily the financial data as well as presenting the accounting information to different categories of users. Financial reporting presents the final step in the accounting information system with the goal to provide information to all interested users regarding the financial condition, business performance and cash flows. The needed information can be found in the basic financial statements. SMEs are obliged to prepare financial statements as well. Some former research draws attention to the fact that the majority of SMEs prepare their financial statements primarily to fulfil their statutory obligations, while the managerial aspects remain insufficient or not-existent. The paper shows the relevance of the principal tools of analysis, especially ratios, towards the improvement of the quality of business decision making.

Information requirements and SME’s financial reporting

The users of financial statements have an influence in determining the form and the structure of financial statements (figure 1). That influence is not only considered as an accounting evidence, but also as the accounting position in the entity. With regard to their position, users of accounting information fall into two categories: internal and external users. Traditionally, it is believed that accounting information is prepared for meeting the needs of shareholders, creditors, suppliers, customers, governments and their agencies which are known as external users. On the other hand, there are information prepared to satisfy the needs of management, employees and other internal users. Internal users in the first place are interested in the growth and development of the entity. In that sense, the information differs from the one the external users need. Internal users need managerial information. External financial reporting is focused on the wider range of users and provides them with summarized and factual values. Internal oriented accounting deals with detailed information and concentrates on both planned (forecasting) and factual values. Those reports are generated by internal rules and expected to present certain parts of business.

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19 Detaljnije vidjeti IFAC (2011) How to Make Your Small Practice a Big Success: Practice Management Tips for SMPs. IFAC: Small and Medium Practices Committee.

Figure 1. Interrelation between users and decisions generated on financial statements

Source: Adjusted as quoted in, D., Britton, A., Jorissen, A. (2007) International Financial Reporting and Analysis, 3rd edition. London: Thomson Learning, pp 218.

The objectives of financial statements are usually focused on satisfying users’ information demands which means providing them with quality information for the decision making process. Needless to mention, there are certain specific and potential constraints of SMEs' financial reporting. SMEs have the same obligation of preparing financial statements as the large entities. Hence, they are usually not obligated to prepare a complete set of financial statements. Most often, they are committed to prepare the balance sheet, profit and loss account and notes to the financial statements. Nevertheless, numerous SMEs do not present any internal reports, neither those that are concerned with historical values or those with forecasting information. Those reports often do not show enough detailed information. They are mostly prepared annually, although monthly or quarterly reporting would be more useful. Previous surveys indicate that most of the SMEs prepare their financial statements for taxation purposes only. In addition, the majority of SMEs present just the basic financial statements that are required by some accounting regulation. Only a few of them use that information for the purpose of liquidity, solvency, activity, economy or profitability analysis. Based on that information, the users of financial statements could obtain information about the past and current financial position, identify the current financial problems and predict the future business trends. Anyway, it would be very useful to analyse their financial statements additionally. It is important to find out the SMEs’ main financial condition and performance ratios in order to further investigate the features and dynamics of their values over a longer period of time.

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Financial statements as the basis for ratio analysis

Business growth and successful development of an entity should be based on quality business information. In that sense, financial statements are the unavoidable source of information of the financial position, performance and cash-flows.

The most significant financial statements that we should take into account when examining the entire business quality and make decision for the future are (figure 2):

1. balance sheet 2. income statement or profit and loss account 3. cash flow statement 4. statement of changes in equity

Figure 2. Financial statements

The balance sheet is the fundamental financial statement that represents company’s financial position and is the basis for estimating the security of business. Basic elements of balance sheet are assets, liabilities and owners equity. The structure of assets, liabilities and equity is especially important, together with the correlation and interdependence of assets, liabilities and capital. In the context of business quality, besides financial condition, efficiency of business is also very important. We usually define efficiency of business as an ability of achieving specific goals. Business goals can be different and that means that efficiency of business depends on a set of principles and defined goals. Business profitability is the most often stated goal. If we understand efficiency in this way it is measured by profit and loss account. While balance sheet represents the financial position in a particular moment, income statement (or profit and loss account) represents company's performance for a particular time period. Basic elements of this statement are: income, expenses and their difference which can be profit or loss.

It is not unusual that the company according to the profit and loss account has successful business; business with the profit but, at the same time has problems in meeting current liabilities. It is possible because revenues and expenses are accounting categories and many times they can be distinguished from cash receipts and cash expenditure. According to that, while measuring business performance, besides balance sheet and profit and loss account, we need to use cash flow statement and statement of changes in owner s equity as well. The cash flow statement contains the information about cash receipts and cash expenditure as well as about their difference, that is, the cash flow. Statement of changes in owner s equity shows all transaction which refers to profit or loss for a particular time period.

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In order to improve the usage of financial information in the context of the decision making process, we need to analyze financial statements. In that context, we can describe financial statement analysis as the process where we convert data from financial statements into usable information for business quality measurement by different analytical techniques, which is very important in the process of rational management. Therefore, to know the current level of business quality is very significant in the context of future business management, since we try to ensure company’s development and existence on the market. Financial statement analysis comes before the management process that is before the process of planning which is the component of the management process. Planning is very important for good management. Good financial plan has to consider all company’s strength and weaknesses.

The task of financial statement analysis is to recognize good characteristics of the company so that we could use the most of those advantages, but also to recognize company’s weaknesses in order to take corrective actions. Because of that, we can say that management of the company is the most significant user of financial statement analysis.

In the process of financial statements analysis it is possible to use the whole range of different instruments and procedures. First of all, it considers comparative financial statements and the horizontal analysis procedure together with structural financial statements and the vertical analysis procedure. By horizontal analysis which is based on the comparative financial statements we try to examine the tendency and dynamics of changes of particular basic financial statements positions. We estimate business efficiency and security of the company on the basis of observed changes. On the other hand, structural financial statements are the base for vertical analysis which allows insight into financial statement structure. Financial statements structure is very significant in the context of business quality.

By financial statement analysis we get acquainted with the business quality, but the questions of the analysis are not solved by horizontal and vertical analysis procedures of balance sheet, profit and loss account and cash flow statement. In the context of measuring business quality on the basis of financial statements, the most significant are different financial ratios formed from basic financial statements.

Financial ratios application in assessing small and medium-sized entities’ business quality

The quality business indicates a safe and successful business. Different financial ratios are used to evaluate the financial condition and performance. Although, there is not a definite list of financial ratios to be used, it is important to interrelate two values of the same kind. The given values would only than be meaningful. Financial ratio analysis provides answers to several questions: is the entity primarily financed by foreign sources of assets, do the customers pay promptly and in accordance with the contracted agreement, are the operating costs too high and do they endanger the long-term stability and business performance (VSBDC, 2004). The significance of certain financial ratio differs depending on the information needs of the users (table 1). Creditors are interested in the information regarding due payment of their loans and the interest. Liquidity and solvency of their clients are of their primary concern. Equity investors (shareholders) are concerned with long-term profitability and financial condition. From the management's point of view, the use of financial ratios, as the relative magnitude of two or more 377

selected numerical values taken from financial statements, can contribute to their decision making process. The strategic orientation of an entity, its environment and the regulatory framework, competition and the branch of industry are of significant importance in understanding and proper interpreting the financial ratios.

Table 1. Ratio analysis and their users

USER RATIORATIO WHAT IT MEASURESWHAT IT MEASURES WHAT IT TELL YOUWHAT IT TELL YOU

OWNERSOWNERS

R e t u r n o n i n v e s t m e n t (ROI)

R e t u r n o n i n v e s t m e n t (ROI)

Return on owners’ capital. When compared wi th r e t u r n o n a s s e t , i t measures the extent to which financial leverage is being used for or against the owner.

Return on owners’ capital. When compared wi th r e t u r n o n a s s e t , i t measures the extent to which financial leverage is being used for or against the owner.

How well is this company doing as an investment?

How well is this company doing as an investment?

OWNERSOWNERS

R e t u r n o n Asset (ROA)R e t u r n o n Asset (ROA)

How well assets have b e e n e m p l o y e d b y management.

How well assets have b e e n e m p l o y e d b y management.

H o w w e l l h a s m a n a g e m e n t employed company assets? Does it pay to borrow?

H o w w e l l h a s m a n a g e m e n t employed company assets? Does it pay to borrow?

MANAGEMENTMANAGEMENT

N e t P r o fi t MarginN e t P r o fi t Margin

Operating efficiency. The ability to create sufficient profits from operating activities.

Operating efficiency. The ability to create sufficient profits from operating activities.

Are profits h igh enough, given the levels of sales?

Are profits h igh enough, given the levels of sales?


A s s e t TurnoverA s s e t Turnover

Relative efficiency in using total resources to product output.

Relative efficiency in using total resources to product output.

How well are assets b e i n g u s e d t o g e n e r a t e s a l e s revenue?

How well are assets b e i n g u s e d t o g e n e r a t e s a l e s revenue?


R e t u r n o n Asset R e t u r n o n Asset

Earning power on al l assets; ROA ratio broken into i ts logical parts: turnover and margin.

Earning power on al l assets; ROA ratio broken into i ts logical parts: turnover and margin.

H o w w e l l h a s m a n a g e m e n t employed company assets?

H o w w e l l h a s m a n a g e m e n t employed company assets?MANAGEMENTMANAGEMENT

A v e r a g e C o l l e c t i o n Period

A v e r a g e C o l l e c t i o n Period

Liquidity of receivables in terms of average number of days receivables are outstanding.

Liquidity of receivables in terms of average number of days receivables are outstanding.

A re rece i vab l es c o m i n g i n t o o slowly?

A re rece i vab l es c o m i n g i n t o o slowly?


I n v e n t o r y TurnoverI n v e n t o r y Turnover

Liquidity of inventory; the number of times it turns over per year.

Liquidity of inventory; the number of times it turns over per year.

Is too much cash t i e d u p i n inventories?

Is too much cash t i e d u p i n inventories?


Average Age of Payables Average Age of Payables

Approximate length of time a firm takes to pay its bills for trade purchases.

Approximate length of time a firm takes to pay its bills for trade purchases.

How quickly does a p r o s p e c t i v e customer pay its bills?

How quickly does a p r o s p e c t i v e customer pay its bills?

W o r k i n g CapitalW o r k i n g Capital

Short-term debt-paying ability.Short-term debt-paying ability.

Does this customer have sufficient cash o r o t h e r l i q u i d assets to cover its s h o r t - t e r m obligations?


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S H O R T- T E R M CREDITORSS H O R T- T E R M CREDITORS Current RatioCurrent Ratio

Short-term debt-paying ability without regard to the liquidity of current assets.

Short-term debt-paying ability without regard to the liquidity of current assets.



S H O R T- T E R M CREDITORSS H O R T- T E R M CREDITORS

Quick RatioQuick RatioShort-term debt-paying ability without having to rely on sale of inventory.

Short-term debt-paying ability without having to rely on sale of inventory.



L O N G - T E R M CREDITORSL O N G - T E R M CREDITORS

D e b t - t o -Equity RatioD e b t - t o -Equity Ratio

A m o u n t s o f a s s e t s provided by creditors for each dollar of assets provided by owner(s).

A m o u n t s o f a s s e t s provided by creditors for each dollar of assets provided by owner(s).

Is the company’s d e b t l o a d excessive?

Is the company’s d e b t l o a d excessive?


Time Interest EarnedTime Interest Earned

Ability to pay fixed charges for interest from operating profits.

Ability to pay fixed charges for interest from operating profits.

Are earnings and c a s h fl o w s sufficient to cover interest payments and some principal repayments?



Cash Flow to LiabilitiesCash Flow to Liabilities

To t a l d e b t c o v e r a g e general debt-paying ability.To t a l d e b t c o v e r a g e general debt-paying ability.



Source: VSBDC (2004) Financial Statement Analysis for Small Businesses; A Resource Guide. Virginia Small Business Development Centre Network, pp 22

Figure 3 and table 2 show several most frequently used financial ratios which are not exclusive in assessing SMEs’ business quality (towards Zager et al., 2008). Moreover, analysts calculate some other ratios, other the above mentioned once.

Table 2: Financial ratios

RATIO WHAT IT MEASURES1. Liquidity ratios measure company’s capability to pay its

payable current liabilities2. Leverage ratios measure how the company is financed

from creditors’ resources3. Activity ratios measure how efficiently company uses its

own resources.4. Economy ratios measure relation between revenues and

expenses, that is, they show how much revenue is achieved per unit of expenses.

5. Profitability ratios measure the return of the invested capital and show the highest manager ia l efficiency

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Figure 3. Correlation between financial statement analysis ratios and basic criterion of good business

BUSINESS EFFICIENCY

FINANCIAL POSITION

BUSINESS QUALITY

Liquidity and solvency ratios determine the financial position of an entity. On the other hand, the economy ratios, the profitability ratios, and the investment ratios reflect business efficiency. The activity ratios are specific due to the fact that they show the financial position and business efficiency. Namely, the total assets turnover affects not only the financial position but also the profitability.

Ratio analysis application - Croatian case study

The formulas used to calculate certain ratio blocks are listed hereafter (tables 3-7). To follow, the most important financial ratios of Croatian SMEs for 2009 and 2010 are presented and interpreted. The summarized data disclosed in the financial statements of small and medium-sized entities have been taken in the calculation of financial ratios of SMEs (FINA, 2011). Financial Agency (FINA) is in charge of the Croatian Register of Annual Financial Statements.

Liquidity ratios indicate an entity's ability to pay off its current liabilities when they fall due. Information used in their calculation is taken from the balance sheet (table 3).

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Table 3. Croatian SMEs liquidity ratios

RATIO FORMULA 2009 2010cash to current liabilities ratio

cash / current liabilities - -quick ratio (cash + accounts receivables) / current

liabilities - -current ratio current assets / current liabilities 1,06 1,04financial stability ratio

noncurrent assets / (equity+ noncurrent liabilities) 0,96 0,97

working capital current assets – current liabilities 12.671.209 7.925.155

Cash to current liabilities ratio measures how much cash (the most liquid assets) is available to pay current obligations, if for some reason immediate payment is demanded. The importance of its value, whether high or law, should not be over- or underestimated, due to the fact that the amount of cash, which is taken into the calculation of this ratio, shows only the amount of cash on a certain date – balance sheet date. The amount of cash can be rather high. For instance, it can reflect a consequence of the last minute cash inflow. Therefore, a quick ratio is a better liquidity measure. It is generally accepted that this ratio should be 1 and or higher. If the ratio is 1 the receivables and cash equal the amount of current liabilities. The current ratio is one of the most important and widely used measures of liquidity. The entity should have current ratio greater than 2 in order to retain the entity's good financial health and to avoid financial difficulties regarding not payment of due current liabilities. When it comes to the Croatian SMEs, a certain margin of safety is present. That confirms that their current ratio is slightly above 1. However, taken into account that Croatian small and medium-sized enterprises are mostly trading companies and that they usually do not have a significant amount of noncurrent assets, it can be concluded that their liquidity certainly should have been higher. Working capital is very popular and widespread measure of liquidity. Its absolute value would not bear any significance for the comparative analysis of entities of different size. The financial stability ratio should also be computed in order to determine the long-term aspect of liquidity protection. The value of this ratio, which is lesser than 1, indicates that in the Croatian SMEs only a smaller portion of current assets is financed by long-term sources. Towards all the above presented ratios, some difficulties in ensuring a proper liquidity on a global level need to be emphasized. If liquidity ratios are calculated for every single entity, the management of that entity can get the valuable information concerning the liquidity and the potential financial difficulties.

Solvency ratios represent the structure of sources of assets and relate the various components of sources – capital and liabilities - to each other or to their total. Own sources of assets are presented through the invested and earned capital (equity). In case an entity does not have enough of its own resources, it raises capital from creditors, investors, etc.

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Table 4. Croatian SMEs solvency ratios

RATIO FORMULA 2009 2010liabilities to assets ratio ( c u r re n t + n o n c u r re n t

liabilities) /total assets 0,72 0,73equity to asset ratio equity /total assets 0,28 0,27liabilities to equity ratio ( c u r re n t + n o n c u r re n t

liabilities) / equity 2,54 2,74

time interest earned (income before interest and taxes) / interests - -

debt factor( c u r re n t + n o n c u r re n t liabilities) /(retained earnings + depreciation)

- -

Table 4 lists solvency (leverage) ratios. The first three ratios illustrate static solvency since they project the structure of assets and sources of assets at certain date. Dynamic solvency can be presented by the time interest earned and the debt factor. Those ratios take into account an entity's ability to settle fixed charges and principal repayments. The time interest earned ratio indicates the extent to which the gross profit is available to meet interests. The higher the ratio, the lesser the solvency. The debt factor indicates the number of years needed to pay liabilities from the retained earnings and depreciation. The results reported in table 4 show that the Croatian SMEs are primarily financed by creditors, investors etc. (73% in 2010). The short-term borrowing is slightly higher than long-term one. Activity ratios depict the number of times a company’s assets are revolved during a given time period. The greater the ratios, the shorter the assets conversion period. Among a block of ratios the most frequent ratios are the total assets turnover, the current assets turnover, the accounts receivable turnover and the inventory turnover (table 5). When it comes to the values of ratios or the recommended thresholds for these ratios there is no general rule although the turnover ratio should aim at being as high as possible.

Table 5. Croatian SMEs activity ratios

RATIO FORMULA 2009 2010total assets turnover total income / total assets 0,64 0,58conversion period of total assets

total income / current assets 1,48 1,36

accounts receivable turnover sales / receivables 3,29 3,09c o l l e c t i n g p e r i o d f o r accounts receivables

365 / accounts receivable turnover 111 118

inventory turnover sales / inventory - -conversion period of inventories 365 / inventory turnover - -

The turnover ratios measure the efficiency of the entity’s resources utilization. The conversion periods of a certain type of assets are based on the turnover ratios. For example, the inventory turnover reflects the number of times an inventory is converted (sold or used) during a year. As presented in table 5, the turnover ratios of Croatian SMEs 382

have a downward trend which implies an upward trend of the conversion periods of total assets as well as the collection period for accounts receivables. An average collection period for accounts receivables is higher than 100 days thus having a negative influence on the liquidity in the Croatian economy.

Economy ratios relate income to expenses and measure how much income is earned per expense. Successful business entities cover their expenses by income. As a result the entity earns profit. The most common economy ratios are listed in table 6. Only the total economy ratio is calculated since only summarized financial data are available for conducting the research of Croatian SMEs. The SMEs had negative consolidated financial result in 2010. in contrast to 2009.

Table 6. Croatian SMEs economy ratios

RATIO FORMULA 2009 2010total economy ratio total income / total

expenses 1,01 0,99

operating economy ratio operating income / operating expenses - -

finance economy ratio finance i ncome / finance expenses - -

extraordinary economy ratio

e x t r a o r d i n a r y i n c o m e / e x t r a o r d i n a r y expenses

- -

Profitability ratios draw attention to the return on investment capital. The most important profitability measures are the return on total assets, the return on equity and the profit margin (table 7).

These ratios can be calculated as net or gross ratios depending on the tax amount. Profit margin shows net income i.e. profit per total income, while the return on assets presents net income i.e. profit per total assets. Equity investors (shareholders) are primarily interested in the value of these ratios. According to the research results, a very low percentage of profitability ratios is evident in Croatian SMEs in 2009. Since SMEs had a consolidated loss in 2010, all the profitability ratios are negative. Those ratios should not be generalized for all the SMEs, because, fortunately, there are SMEs which had earned profit in 2010.

Table 7. Croatian SMEs profitability ratios

RATIO FORMULA 2009 2010 net profit margin ( n e t i n c o m e + i n t e re s t

expense) /total income 0,39% -2,11%

gross profit margin (gross income + interest expense) / total income 1,38% -1,08%

net return on total assets (ROA)

(net income + interest expense) / total assets 0,25% -1,22%

gross return on total assets (gross income + interest expense) / total assets 0,88% -0,63%

return on equity (ROE) net income / equity 0,87% -4,56%383

Ratio analysis is a very popular management instrument. One of the reasons is their simplicity in indicating business strengths and weaknesses. However, there are some inherent limitations of financial ratios' application in the evaluation of SMEs' business. (Alexander, Britton i Jorissen, 2007; SBDCN, 2004). First of all, financial statements do not comprise qualitative, nonfinancial information, such as the quality of product and service or the customer satisfaction. Although such information cannot be found in the financial statements, similar conclusions can also be drawn with the usage of tools and techniques of financial statements analysis. Finally, needless to say that, financial ratios are a very useful tool for business analysis, but they have to be used properly.

Conclusion

Small and medium-sized enterprises have been the most important part of the economy of every country. SMEs management requires quality information. The financial statements are a significant source of information used in business governing and business quality evaluation. The business quality of the entire company can be measured and examined on the basis of financial statements. From the external users' point of view, financial statements are the fundamental base for measuring of business quality of an entity. In that context we examine true and fair presentation of financial position, business efficiency and cash flow. A successful business is the business operation that results in the corresponding level of security and efficiency of business over a longer period of time. Financial position is examined, first of all, on the basis of a balance sheet. The efficiency is measured on the basis of the profit and loss account. The data from the cash flow statement needs to be considered in order to get a more complete picture about business quality. The condensed statement of financial position and efficiency of business is registered by financial ratios. Accordingly, financial ratios can be examined in the context of measuring business quality. Different ratio values define different levels of business quality. Some significant presumptions for the future development and existence of the company can be made by defining the current business quality rate. This is important for all enterprises, especially for SMEs.

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194692361 Administracion Para Emprendedores 1ed Antonio Cesar Amaru Maximiano PDF 150309123803 Conversion Gate01