Planning your Business with Managerial Accounting Ratios

Mr. Busalla (chairman of the board of directors of the Rodriguez Company) was reading a copy of the auditor’s report stating that the company is facing two big problems for 2009. They are investment opportunities for the idle funds because financial statements show too much liquidity, and the fast pacing of uncollectibles or a high portfolio risk. Rodriguez Company is primarily engaged in lending.

Too much liquidity means a lot of idle funds. High portfolio risk means that a large amount of receivables is placed under the label “more than 365 days.” The collection department is in hot water.

The facts above were brought out after the visit of the external auditors. The financial statements of the Rodriguez Company will undergo a rigid financial analysis using some appropriate managerial accounting tools to evaluate its financial performance of the business year just recently concluded.

As the internal auditor of a company, I always suggest that these two big issues be given attention. Total assets amounted to almost $20,000,000, but the asset turnover is only 2%, 3 points lower than the industry trend. I further have stated that managerial accounting tools have been ignored by management for a long time. Now it is time for accounting and management to sit down and work together.

What AreThese Simple Tools and Their Practical Application?

There are a lot of managerial tools, but below are some of the most commonly used ratios that help managers provide the basis for their decisions. They come in different forms like theories or concepts, models, or simple ratios. Managers will only have to be critical in applying them.

<em>Liquidity ratios</em> provide information about a firm’s ability to meet its short-term financial obligations. This tool is used by companies that are concerned with their ability to have available funding for the present operations. Businesses like trading and construction companies are the most common types of organizations that find these ratios practical. Trading companies, for example, need to have available funds all the time to meet their daily operational needs.

The most popular under this type is the current asset ratio. Let us take a look at the equation: Current asset/current liabilities: If the company has $300,000 current assets and $150,000 current liabilities, the ratio will be 2:1; for every $1 of current liabilities (trade payables, loan payables, and other short-term liabilities), the company has $2 current assets (cash, accounts receivables, marketable securities, inventories and prepayments) to pay it off.

But being liquid is not enough. Liquidity must be measured in terms of the industry trend: When we say industry trend, what are the rates of other businesses of the same category? If the company’s rate is below the trend, it is not performing well; and if the rate is too high, it means that a lot of cash is not used to generate revenues. In the example above, if the industry trend is 1.50:1, the company is performing well compared to the industry.

Asset Turnover Ratios show how efficiently a firm utilizes its assets like buildings constructed for rent, receivables, and inventory. These ratios are called efficiency ratios or asset management ratios. The formula for this ratio is revenue/total assets. If the company has $100,000 and its total assets are $10,000,000, the asset turnover ratio is .01 which means for every $100 asset, the company is only earning one cent. By using this ratio, management will know that investment in assets is not quite good so it has to find ways to utilize assets in order for these to earn revenues.

Financial Leverage Ratios provide indication if the firm can survive a long-term solvency. One example is the debt equity ratio. The formula for this ratio is total debts/total equity and it is ideally 1:1, meaning assets are provided equally by outsiders and inside parties. If the ratio grows higher, there is a fear of insolvency, because what If the company cannot pay its obligations? If the ratio is going down, it becomes an advantage because the company can survive by its own resources.

Profitability Ratios offer several measurements of the firm’s success in generating profits. These are the easiest ratios to compute. For the gross margin ratio and net profit ratio, divide the gross margin or net income by the net sales. So if the gross margin is $20,000, net income is $10,000 and the net sales is $100,000, then the gross margin ratio is $20,000/$100,000 or 20%, and the net income ratio is $10,000/$100,000 or 10%.

How Will These Managerial Accounting Ratios Be Used Effectively?

To be effective, the manager must be concerned with the following:

1. Data gathered must be accurate. Inaccurate data produces inaccurate results.

2. Ratios obtained should be compared with the industry trend. Even if the company is liquid, what is its liquidity compared to the industry?

3. In budgeting, since ratios are results assumptions, managers should consider the business environment and its effect on the outcome of the forecasted figures.

In-Depth Analysis of Rodriguez Company

During the exit conference with the external auditors, the following were emphasized:

Use of Assets to Generate Revenues (Asset Turnover Ratio):

1. The asset turnover ratio shows how much of the total assets are utilized to earn revenues. Out of the $20,000,000 cash, only 40% or $8,000,000 is utilized to earn revenues, and the actual earnings based on $8,000,000 is $200,000. The asset turnover ratio is net savings/total assets or $200,000/$20,000,000 =1%. Had $12,000,000 been loaned out, we could have had an additional $4,800,000 net savings.

Portfolio Risk (Efficiency in Collection)

2. The receivables turnover is 1.2 or total accounts receivables, $12,000,000/ average accounts receivables balance, $10,000,000, which means that the company can only collect 1.2 times a year compared to other industries that could make as much as three times. This causes the delinquency status of the receivables. Digging further, if the required average collection days are 180, and the age of receivables for the company is 360 days (standard days in a year)/receivables turnover or 360 days/1.2 = 300 days means that the company was not able to collect receivables on time.

Conclusion - Rodriguez Company

As a conclusion, Rodriguez Management must really work hard for the above findings. These results are the product of using appropriate managerial accounting tools.

What are the probable investments that the company are considering?

1. Improvement for its condo hotel.

2. Micro financing.

3. Online business.

Strategies made to improve receivables collection:

1. Restructurization of the loan interest rate program.

2. Reinforcement of the human resources assigned in the collection department.

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Skyscraper, FreeDigitalPhotos, by graur codrin

Calculator and money, FreeDigitalPhotos, by Arvind Balaraman