12-4 Financial Decision-Making
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Using Financial Information – Financial statements are important management tools for business owners and managers. Financial statement present summaries of the financial activities of a business. Managers who understand the information in financial statements will be able to make decisions that result in the wise use of the company’s money.
Important Financial Information – The three most important elements of a company’s financial strength are its assets, liabilities, and owner’s equity. Three other key financial elements for a business are the amount of sales, expenses, and profits. A company reports its assets, liabilities, and owner’s equity on the balance sheet. Sales, expenses, and profits for a specific period are reported on the company’s income statement.
Understanding Financial Performance Ratios – Managers use the financial elements found on the financial statements to calculate financial performance ratios. Financial performance ratios are comparisons of a company’s financial elements that indicate how well the business is performing. Some important financial performance ratios are the current ratio, return on equity ratio, and net income ratio.
Current Ratio – Current assets compared to the current liabilities is the current ratio. Current assets are those that the business could convert to cash within one year. Current liabilities are all payments that the business must make within one year. The current ratio tells you if the business can pay debts when they become due. The current ratio should be at least 1:1 for a healthy business. A 1:1 ratio means that there are at least as many current assets as current liabilities.
Debt to Equity Ratio – The company’s liabilities divided by the owner’s equity is the debt to equity ratio. The debt to equity ratio tells you how much the business is relying on money borrowed from others that will have to be paid back rather than money provided by the owners. Most banks want to see a debt to equity ratio no higher than 2:1. Too much debt puts a business at risk because it may have trouble meeting its obligations to its lenders.
Return on Equity Ratio – The net profit of the business compared to the amount of the owner’s equity is the return on equity ratio. The return on the equity ratio shows the rate of return the owners are getting on the money they invested in the company. It should be compared to the return they could receive if they used their money in other ways such as savings, investing in other companies, or purchasing stocks and bonds.
Net Income Ratio – The total sales compared to the net income for a period such as six months or a year is the net income ratio. The net income ratio shows how much profit is being made by each dollar of sales for the period being analyzed. You should compare the net income ratio to past periods and to competing companies. The ratio will show if additional sales are as effective in adding to the company’s profit as those in the past.
Making Financial Decisions – Managers are responsible for the financial health of their company and for the specific areas of the company under their control. If adequate finances are not available, the work that is required will not be done as well or as quickly as need. On the other hand, if more money than is needed is used for certain operations, there may not be enough for other parts of the company.
The first step in financial decision-making is preparing a budget. The budget identifies the amount of money needed for all parts of the business to complete planned activities. It also projects what types and amounts of income will be earned from the sale of the company’s products, services, and other investments.
Once a budget is developed and approved, managers use the budget as a guide to operate the business. They regularly check to see if income and expenses are meeting budgeted amounts. Income should be as high or higher than planned. Expenses should not exceed the budgeted amount. Managers get regular financial reports and examine them carefully, looking for discrepancies. Discrepancies are differences between actual and budgeted performance.
Discrepancies let managers identify problems before they become serious enough to harm the business. They might also see areas where financial performance is better than what was budgeted.
The final step is to make needed adjustments. If income and expenses are similar to the budget, the manager will not need to take action. If there are financial problems, managers will take corrective action to tyr to bring performance back in line with the budget. That might include finding ways to improve revenue as well as seeking ways to cut expenses. In some cases, performance cannot be improved or factors outside the manager’s control are responsible for the poor performance. The managers may have to adjust the budget. This should be done as a last resport because the budget was carefully planned.
At the end of the period covered by the budget, the business will prepare new financial statements. It will use the results to determine the financial success of the operations. The company will also use the results to improve the budgeting process in the future.
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