Basic financial accounting information for a business comes from the preparation of an income statement and a balance sheet. These financial statements provide a record of the profit performance of a company and its financial condition at a point in time. Managers use this data to create certain ratios that analyze various aspects of a company's performance, determine strengths and weaknesses and develop strategies for improvement.
The financial accounting information from a company's financial statements does not mean much by itself. However, when this information is used to prepare ratios, it can measure current levels of performance, reveal trends and be used as goals for planning. The primary financial ratios measure profitability, liquidity and debt leverage.
Managers look at two ratios to gauge profitability: gross and net profits. Gross profit measures the profit results of a company's basic business; it is calculated by subtracting cost of goods sold -- materials, labor and supplies -- from total revenues. If the gross profit is not sufficient, management could make decisions about changing the product mix to more profitable items, improving labor productivity or finding cheaper sources of materials.
An insufficient net profit would lead a manager to find ways to reduce overhead costs, look for lower interest rates on loans or reduce administrative salaries.
Businesses need to maintain adequate liquidity to pay their bills on time. The current ratio measures the level of liquidity; it is calculated by dividing current assets by current liabilities. Most businesses need a minimum current ratio of 2:1 to have sufficient liquidity.
If a manager sees that his current ratio is inadequate, he may decide to inject more capital into the business or enact tighter credit policies for his customers.
A business must maintain a reasonable balance between the amount of debt outstanding as compared to the amount of shareholders' equity. Most bankers do not like to see more than $2 in debt for each $1 in equity.
If a business is looking to expand and purchase more fixed assets, the debt-to-equity ratio will dictate whether the company is able to borrow the funds for expansion or will need to seek additional outside capital. The manager must make a decision on whether to borrow more money and pay the interest rate or to solicit additional investors, which could lead to the payment of more dividends.
Based on the analysis of the financial accounting information and calculation of the ratios, managers can identify weak areas that need improvement and develop strategies to strengthen the business. Managers can decide which employees will be responsible to implement the strategies and establish goals to measure their success in achieving the objectives.
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