Key accounting ratios to calculate the financial health of organizations.

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Finance or money is the key resource in any organization. Quiet often people will mention money as the bloodline of business. Every organization needs money to run its operations and expand its activity when needed. Because is a key resource of an organization, it has huge influence on what the organization can do (the capability side of things) and able to do (the capacity side of things).  The available funds will determine, what kinds assets the organization acquire and people it can employee. The assets and employees in turn determines what kind of goods and services it can produce.

However, on the other hand finance is a not always available in constant supply and that puts a constrain on the organization. If finances of an organization is not managed properly, the organization can go into bankruptcy (not able to meet it’s obligations in terms of paying it’s creditors, loan debts, employees and etc in order to operate), liquidation (assets will be sold off to offset debts) and eventual led to closure or put up for sale.

Financial performance is crucial

Financial health or performance of the organization is important for the organization’s continuity of operations. Financial performance is the financial results achieved by the organization. Some of the indicators of financial performance include the following;

Profitability

whether the organization has made profits for it’s shareholders. If it’s a government organization is a question of whether there was improvements in the quality of services provided to the citizens as per the budgeted allocation from the government

Cashflow

How much money the organization is able to generate as income and able pay for its’ expenses to sustain itself.

Budget and cost management

Since financial resources are limited, almost every organization operate within a budgeted ceiling. So, managing the cost of various expenses within the organization is important. The management has to make sure budgeted amount is expensed as per the budgeted activities.

Dividend paid to shareholders.

Investors or shareholders of the business wants are return on their investment and organizations are expected to make profit and pay them dividends.

Loan repayments

Most organizations borrow finance from financial markets like the banks and other financial organizations to provide them with the money needed to finance their operations. These organizations will require the organization to pay their interest and repayments.

Financial health check

When an investor or government wants to check the financial health of an organization, they will analyze the published financial accounts of the organization. Especially, if it is a business organization. Then they can apply what is termed as Accounting Ratios. According to Tony Mordern in his book Principles of Strategic Management, the key ratios include the following;

Profit Margin   = Net Profit before interest and tax / Sales

Return on capital Employed  (ROCE) = Net profit before interest and tax / Capital employed

Return on Net Assets (RONA)           =  Net profit before interest and tax / Net assets

Return on equity (ROE) or Return on Share Capital  (ROSC) = Net profit after interest and tax / Share holders’ capital

Profit per employee = Net profit before interest and tax / Total number of employees

Asset turnover   = Sales/ Net assets

Stock turnover  = Sales/stock

Debt turnover = Sales/Debtors

Average collection period = Debtors/Average daily sales

Effectiveness of administration =  Cost of Administration/Sales

These ratios indicate the level of return being generated by the assets and people being employed by the organization. They show how fixed assets are used to generate profit, and how they working capital is used in generating sales and cash flow. They also so the speed and efficiency with which the business completes its transactions with customers.

The other two critical accounting ratios used to indicate the degree to which the organization can finance its operations and pay its debts.

Current Ratio          =    Current Assets/Current liabilities

Acid test                   =    Liquid assets (cash + debtors) / Current liabilities

Any business or service organization must ensure that it has enough cash resources by which to pay its way, and proper cash flow on which to base its operations. The above two ratios indicate any level of “overtrading” which is trying to operate a level of business activity that exceeds the financial capacity of the organization to operate that business.

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