Accounting -> Topics -> Understanding and using accounting information -> Discussing long term stability
Discussing long term stability
Selection of the key ratios is again important. It is easy to use a multitude of 'gearing' ratios, however, only one is necessary. Most people favour liabilities to total assets as a measure of gearing.
The references are not consistent in their definition of ratio items. For instance, some define the rate of return ratio using "owner's equity" whilst others use 'average owner's equity'. Either is acceptable providing you are consistent in the application of these measures. Where relevant you should use an 'average' figure.
Two other possible ratios to use are:
debt ratio = Interest bearing debt/total assets
interest coverage ratio = Net cash flow from operations + interest/interest expense
It is important that you graph the ratios stated above along with liabilities: total assets. The movement of these ratios must be explained and, if provided, compared with a benchmark.
By referring to the financial reports you should attempt to explain why changes have occurred.
Before condemning a business in respect of it's long term stability check the nature of the non-current assets. If these assets have been acquired some time ago and are shown at historical cost then it may be possible that they are considerably understated in value, which means the gearing situation is not as bad as it appears.
On the other hand a business, which has a reasonable gearing, may still fail if it loses a major account or suffers the failure of a major customer/debtor.
An area you may wish to pursue in your report concerns items which are certainly not measurable but vital in performance evaluation. One such example is the quality of the management of the business you are evaluating.
The advice you provide to management may be non-financial such as providing better staff training, improved customer relations and use of the internet. You may also suggest that the business widen or contract operations.