You are running your company — hiring employees, making sales and paying the bills. The business seems profitable, but is it making as much as it should be? The bookkeeper is paying the bills, but sometimes cash seems a little tight. How liquid is the business? Do you have enough cash flow to operate comfortably? Effective financial information systems can answer all of these questions for you.
TL;DR (Too Long; Didn't Read)
Financial information systems let you know what is going on in your company. You need this information to identify profitable areas and any problems that need your attention.
Important Elements of a Financial Information System
The important elements of an accounting information system are metrics for profitability, liquidity and debt leverage. These metrics are like looking at the instruments on the dashboard of your car that show information about how the engine is performing, only, in this case, they are gauges about your business's performance.
Let us take a look at a few of these metrics by using these figures from the Hasty Hare Corporation, a manufacturer of sneakers for rabbits.
- Cash in banks: $90,000
- Accounts receivable: $220,000
- Inventory: $215,000
- Current assets: $525,000
- Fixed assets: $675,000
- Accounts payable: $145,000
- Short-term bank loans: $80,000
- Current liabilities: $225,000
- Long-term debt: $415,000
- Equity: $765,000
- Working capital: $300,000
- Sales: $3,200,000
- Direct labor: $960,000
- Cost of materials: $800,000
- Overhead expenses: $1,100,000
- Interest: $35,000
- Taxes: $80,000
- Depreciation: $40,000
- EBITDA: $340,000
- Net profit: $185,000
Metrics for Profitability
Three important measures of profits are gross profit, EBITDA and net profit.
Gross profit: Gross profit is calculated by subtracting the cost of goods sold (direct labor plus cost of materials) from total sales. Hasty Hare has a gross profit of $1,440,000 ($3,200,000 minus $960,000 less $800,000). This figure can also be expressed as a gross profit margin of 45% ($1,440,000 divided by $3,200,000)
Gross profit margin measures a company's labor productivity and the ability to control the cost of materials. Compare your gross profit margin to your company's standard manufacturing costs for early warnings of deviations that need attention.
EBITDA: EBITDA is a measure of the company's earnings before interest, taxes, depreciation and amortization. Hasty Hare has an EBITDA of $340,000 (gross profit of $1,440,000 less overhead expenses of $1,100,000).
EBITDA is a gauge of a company's profitability from its core operations without the cost effects of financial structure, tax planning and non-cash accounting entries for depreciation and amortization.
Net profit: The final result of reporting all sales and accounting for all expenses is the net profit. This is the figure that creditors and analysts look at to assess management's ability to run all aspects of a business and produce a reasonable profit.
Hasty Hare has a net profit of $185,000 and a profit margin of 5.8% ($185,000 divided by $3,200,000). You can make comparisons to similar companies in your industry to determine how well you are doing.
Metrics for Liquidity
While profits are a measure of a business's operating efficiency, liquidity metrics gauge your ability to pay expenses and meet debt obligations.
Current ratio: This ratio is calculated by dividing current assets by current liabilities. Hasty Hare has a current ratio of 2.3-to-1 ($525,000 divided by $225,000); this is $2.30 in current assets for each $1 in current liabilities.
Generally, you should aim for a minimum current ratio of 2-to-1, which is considered a comfortable proportion.
Accounts receivable turnover: Selling on credit terms is a competitive necessity, but the outstanding receivables must be paid on time to prevent disruptions in your cash flow. The accounts receivable (A/R) turnover metric measures the effectiveness of your collection procedures.
This turnover ratio is calculated by dividing annual sales by the accounts receivable balance. As an example, the A/R turnover for Hasty Hare is 14.5 times ($3,200,000 divided by $220,000).
The number of account receivables days outstanding is 25 (360 days divided by 14.5). If Hasty Hare is giving its customers 30-day terms, then 25 days outstanding would indicate excellent collection of receivables.
Cash turnover: You always want to have enough cash in the bank to finance operations. Sales divided by working capital, which is current assets minus current liabilities, is a ratio that indicates adequacy of liquid assets.
Most of the time, you want a sales volume of five to six times working capital. Hasty Hare has a cash turnover of 10.6 times, so they are getting a good turnover of their working capital.
Metrics for Leverage
Some debt is good because it increases the return on equity. But too much debt can be dangerous in the event of an economic downturn and a slowdown in sales. Lenders want their debt paid in good times and in bad times.
Debt/equity ratio: The ratio of debt to equity measures a company's financial leverage and risk. For most industries, you want no more than $1 in debt for each $1 in equity.
Hasty Hare has a debt/equity ratio of 0.65 (($80,000 plus $415,000) divided by $765,000). This indicates a well-capitalized company.
If you are thinking about borrowing money, take a look at this ratio to see how additional loans will affect your financial leverage.
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