Analysis of the Operation and Financial Condition of the Enterprise

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Analysis of the Operation and Financial Condition of the EnterpriseAt the normal level this ratio should not exceed 40%. Creditors usually want tosee lower debt ratios, because it is more certain that they would without any obstructionsreceive the amounts lent. Higher debt ratio means that high interest rate is paid on theloans, and the terms of crediting will be strict or an enterprise may even lose the chance toreceive a loan.Risk plays the main role in assessment of the level of liabilities. Most often thereare two types of risk that the enterprises may face: business risk associated with normal level of activities in the operating conditions; financial risk arising from the method by which the enterprise assets are financed.The underlying principle is as follows: if the business risk is high, neither thefinancial risk should be undertaken.The size of the level of liabilities depends also on the state legislation regardingissuing of loans, the interest rate as well as the peculiarities of an enterprise, the area ofbusiness etc. conditions.The financial independence of an enterprise is also described by a measure calledthe independence ratio which is also called the financial leverage (gearing) which iscalculated by dividing the liabilities of an enterprise by its equity:Financialleverage =(gearing)LiabilitiesEquity capital(4.9.)Ratio shows, what the amount of borrowed capital payable per one lat of equity capitalis. Dynamic increase in this ratio may evidence the ability of the enterprise to expand itsoperations on the account of raising the debt capital. At the same time it may be anindicator of a growing financial dependence on borrowed capital.Experts believe that if the level of this ratio has reached 1, the financial stabilityof an enterprise is under the threat, however, there is no one single solution regarding thecritical limit of this ratio. This ratio depends on the type of business activities and the rateof turnover of current assets. If the turnover of current assets is high, the critical limit ofthis ratio may considerably exceed 1 without seriously affecting the financial autonomy ofan enterprise.Creditors usually select the lower level of this measure. High level of dependencefrom external debt may considerably impair the conditions of an enterprise incircumstances when the rate of sales of goods is decreasing, because the expenses forpayment of interest on loans are believed to be relatively fixed, i.e., the expenses which inother similar conditions would not decrease proportionally with the reduction in the salesvolume of goods.Evaluation of this measure depends on the following positions: the level of the ratio in other industries; what the possibilities are for an enterprise to receive further loans; stability of business performance.74
Analysis of the Operation and Financial Condition of the EnterpriseThere is an approach in some books on economy that are devoted to variousconcerns about the balance sheet analysis, according to which the relationship between theshare of equity capital and the break-even point of sales.The concept of this approach lies in the assumption that nobody except theowners of an enterprise should be obliged to provide any capital required for performanceof business activities during the period when the amount of sales does not cover all of theexpenses according to the prime cost of the products as it has been established. Therefore,the higher the break-even amount, the larger equity capital must be made available. Thisdirectly proportional correlation is expressed in the following equation:Theoretical amount of equitycapitalTotal liabilities=Break-even amount of salesAmount of sales for theperiod(4.10.)Theoreticalamount ofequity capital=Break-even amount of sales * Total liabilitiesAmount of sales for the period(4.11.)Consequently, if the size of equity capital reflected in the balance sheet is lowerthan the theoretical amount, it can be concluded that the share of representation of equitycapital in the relationship between income and expenses is low, but the structure of capitalis risky for creditors.We expect that the estimate of the safe share of equity capital in the compositionof liabilities according to the method shown will be useful for assessment of the financialstability for both the enterprise and its business partners.The ability of an enterprise to pay the interest out of its profit without touchingthe equity capital is represented by the measure called the interest cover:Interest cover =Profit before % and taxAmount of interest payable(4.12.)This ratio should be well above 1; then it would mean that an enterprise iscapable of paying for all interest out of its profit as well as that there are still spareresources left. If the ratio is 1, it means that an enterprise can only pay interest out of itsprofit, but then it would not have any profit left and there would be no need to pay theincome tax. There would be no net profit and the owners would not receive any dividends.If it is below 1, an enterprise has been operating at a loss, subsequently there is no profit,from which any interest payable should be covered and additional assets for payment ofinterest should be sought.75
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Analysis of the Operation and Financial Condition of the Enterprise

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