Financial Ratios: Impact on Feasibility Study
Feasibility Study is designed to objectively create an assessment of the economic viability and marketability of proposed future projects including expansion, improvement and diversification of the existing ones. Financial Ratios have provided in depth analysis in financial accounting and have helped business owners to analyze the current financial status of their own business as well as plan out future expenditures.
Financial Ratios are not only helpful to a Feasibility Study but also to existing businesses as well. Most business owners rely on the financial statements given by their Accountants and not on Financial Ratios. Although the Income Statement can suggest the financial performance of the business; he must also realize how liquid he is; how long can he get his return of investment, how many days will it take from the time he purchases inventory, sells the products, pays for his liabilities and back to the beginning of the cycle again? These will be viewed further through Financial Ratios.
Financial ratios have great contributions to business owners. Financial Ratios are the turning points in a feasibility study. Financial ratios are determining factors in the decision making for feasibility studies. Whether a project is feasible or not, financial ratios can answer it.
The following financial ratios are commonly used in conducting a Feasibility Study:
- Profitability Ratios – are financial ratios in Feasibility Study which measure the profitability of the business based on certain accounts. Profitability ratios include Gross Profit Margin, Net Profit Margin, Return on Assets and Return on Equity.
- Gross Profit Margin = Gross Income / Net Sales
- Net Margin = Net Income / Net Sales
- Return on Assets (ROA) = Net Income / Total Assets
- Return on Equity (ROE) = Net Income / Total Equity
Gross Profit Margin measures the gross profit of the company after deducting the Cost of Goods Sold from Net Sales. This financial ratio will determine if how much is the gross profit rate in terms of the specified Net Sales. If Gross Profit rate decreases, the business owner must review and control its direct costs as these relates to the selling price.
Return on Assets and Return on Equity measure how much is the Net Income compared to its Total Assets or Total Equity. The increase in ROA reflects greater profitability while increase in ROE attracts potential investors.
- Risk Ratios – are financial ratios in Feasibility Study that measure the extent of debt in the business operation under certain circumstances. Risk Ratios include Debt Ratio and Debt to Equity Ratio.
- Debt Ratio = Total Liabilities / Total Assets
- Debt to Equity Ratio = Total Liabilities / Total Equity
Debt Ratio measures the extent of borrowed funds against the Total Assets while Debt to Equity Ratio calculates the borrowed funds from creditors against the funds raised by the owners.
- Liquidity Ratios - are financial ratios in Feasibility study which measure how much Assets can cover up the Current Liabilities of the business. Liquidity Ratios include Current Ratio and Quick Ratio.
- Current Ratio = Total Current Assets / Total Current Liabilities
- Quick Ratio = (Current Assets – Inventory) / Total Current Liabilities
Current Ratio and Quick Ratio calculate the ability of the business to pay off short term liabilities. Quick Ratio or Acid Test Ratio is a financial ratio that shows whether the company has enough cash to meet its short term obligations without considering the inventory. An ideal Current Ratio is 2:1 while 1:1 Quick Ratio is more preferred.
- Activity Ratios – are financial ratios in Feasibility Study that are used to determine the rate or length of time of each activity involved in the business. Activity Ratios include Inventory Turnover Ratio and Accounts Receivable Turnover
- Inventory Turnover Ratio = Cost of Goods Sold / Inventory
- Accounts Receivable Turnover = Credit Sales / Accounts Receivable
Inventory Turnover Ratio measures how efficiently inventory is being managed by the company. A higher inventory turnover ratio indicates a well improved sales turnover. Accounts Receivable Turnover on the other hand indicates how well Accounts Receivables are being collected.
- Operating Cycle – is a financial ratio in Feasibility Study which determines the number of day’s cycle from the purchase of inventory to the sale of goods until the collection has been received.
- Operating Cycle = Number of days of Inventory + Number of days of Receivables
- Net Operating Cycle = Number of days of Inventory + Number of days Receivables – Number of days Purchases
The above Financial Ratios are derived from:
- Number of days of Inventory = Inventory / (Cost of Goods Sold / 365 days)
- Number of days Receivable = Accounts Receivable / (Credit Sales / 365 days)
- Number of Days Purchases = Accounts Payable / (Purchases / 365 days)
- Payback Period – is a financial ratio in Feasibility Study which determines the number of days an investor can recover the cost of the project
- Payback Period = Cost of the Project / Annual Cash Inflows
- Break Even Point – is a financial ratio in Feasibility Study which determines the Revenue being equal to the expenses. This is usually determined in a Feasibility Study in order to make sure that expenses are still covered up even if Sales is declining.
- Break Even Point = Total Fixed Costs / (Selling Price – Variable Cost per Unit)
Determining the right Financial Ratios in a Feasibility Study is dependent upon the needs of the business owner. It is very important that the assumptions in which the Financial Statements of the Feasibility study are derived are adequately identified in order to come up with the appropriate Financial Ratios for the Feasibility Study. Thus, appropriate Financial Ratios can create relevant and timely decisions for the business.