Section 12.1 Financial Ratios Section 12.2 Break-Even Analysis

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1 Section 12.1 Financial Ratios Section 12.2 Break-Even Analysis

2 OBJECTIVES Explain what a financial ratio is Describe how income statements are used for financial analysis Compare operating ratios and return-on-sales ratios Describe the ratios developed by using balance sheets Explain the importance of return on investment 2

3 What Are Financial Ratios? One way entrepreneurs can see relationships, patterns, and trends is by using charts. Pie charts and bar graphs are very helpful in illustrating financial ratios. A pie chart has slices that represent portions of the whole. A bar graph uses vertical or horizontal bars to show data. 3

4 Analysis Based on an Income Statement With Sales Data Analysis, an income statement is used to review monthly sales totals in order to determine how much the business can afford to spend. Monthly income statements are also used to forecast future sales. Entrepreneurs also use income statements to measure how cost of goods sold and operating expenses affect profits. Same-size analysis is a comparison of total revenue or other financial data against that same data converted into percentages. 4

5 Example of Same-Size Analysis (Income Statement) Income Statement Amount Calculation % of Sales Revenue (sales) $10000 (10000/10000)* % COGS $4000 (4000/10000)*100 40% Gross Profit $6000 (6000/10000)*100 60% Expenses $3500 (3500/10000)*100 35% Pre-tax Profit $2500 (2500/10000)*100 25%

6 Ex of Same Size Analysis (Comparative Income Statements) January February Income Stmt Amount % of Sales Income Stmt Amount % of Sales Revenue % Revenue % COGS % COGS % Gross Profit % Gross Profit % Expenses % Expenses % Pre-tax Profit % Pre-tax Profit % As you can see the revenue dropped from 50,000 in January to 40,000 in Feb, However in February the cogs reduced from 38% to 26%. As a result, the company had a increase in pre-tax profit over January, despite having a drop in sales. Which month do you think was better for this company?

7 Income Statement Ratios The operating ratio is the percentage of each dollar of revenue, or sales, needed to cover expenses. Return on sales (ROS) or Profit Margin is the financial ratio calculated by dividing net income by sales. 7

8 Operating Ratio/ROS Examples Using the formula for operating ratios, If your company shows sales of and insurance expense of 1,000, what is the operating expense for insurance? Rent of 10000/mo and sales of 10000? If the sales for a company is 30,000 and the net profit is $6000, what is the ROS? Note: although a high ROS is usually a good indicator a business success, the ROS alone does not provide the entire picture. Example- A business that sells high priced items can be profitable with a low ROS, while a smaller retailer who sells inexpensive items may need an ROS of 25% or more.

9 ROS Chart ROS Margin Range Typical Product Very Low Low 2-5% 6-10% Very high volume/price High volume/price Moderate High 11-20% 20-30% Moderate volume & price Low volume/price Very High 30% & up Very low volume/ price

10 Ratios from Balance Sheets The debt ratio is used to monitor the debts of a business. This is the ratio of a business s total debt divided by its total assets. The debt-to-equity ratio is the ratio of the total debts (liabilities) of the business divided by its owner s equity. 10

11 Debt & Debt to Equity Ratio Example Using the formula for debt ratio, if a company had total liabilities of $100K & total assets of $500K, what is the debt ratio? What is debt is 200K and assets are 700K? Note: Be careful with high debt ratios you might not be able to pay interest and it may be difficult to obtain credit. The ideal debt ratio is determined by company s ability to pay loan payments and industry standards. If a company has total debt of 100K and OE of 400K, what is the debt to equity ratio? What is debt was 250K and OE was 275K? Note: Because the value of a business is the Owner s equity (OE), you need to monitor the debt to equity ratio carefully.

12 Ratios from Balance Sheets The balance sheet also tells you about a business s liquidity (ability to convert assets to cash). The two ratios that can help a business keep and eye on liquidity is: The quick ratio is the comparison of cash to debt. The current ratio is current assets divided by current liabilities. 12

13 Quick Ratio and Current Ratio Examples Emily M has cash of 150,000 and stocks worth 50,000. Her current debt is 100,000, what is her business s quick ratio? Note: the quick ratio tells if the business has enough cash to cover its current debts. Because a business should be able to pay its debt, the quick ratio should always be greater than 1 to 1. Chip has current debts of 100k and current assets of 250k, what is his current ratio? Note: the current ratio provides information about the liquidity of the business. The current ratio would indicate whether a business can sell its assets to pay debts.

14 Return on Investment (ROI) Return on investment (ROI) shows the profit on the investment expressed as a percentage of the total invested (when expressed as a percentage, it is also referred to as the rate of return). 14

15 Break-Even Analysis OBJECTIVES Explain the importance of the break-even point Perform a break-even analysis 15

16 What Is a Break-Even Point? On an income statement, if the costs and expenses were exactly equal to the sales, there would be neither a profit nor a loss and net income would be zero. This is called the break-even point, because the business has sold exactly enough units to cover costs. Break-even analysis examines the income statement to identify the break-even point for a business. A breakeven analysis examines how many units of a product (or hours of a service) a business must sell to pay all its costs. 16

17 Break-Even Analysis The gross profit of the business (Total Sales -Total COGS) is used to pay operating expenses. Break-even units are the number of units of sale a business needs to sell to arrive at the break-even point (where the bottom line is zero). 17

18 Break-Even Analysis Example Pies in the skies has total sales revenue of 10,000 or 1,000 pies* $10/pie. Note: In this example The Unit of Sale for Pies in the Skies is one pie The selling price/pie is $10 The cost of goods sold in $6/pie Based on this what is the gross profit/pie? Based on this example what is the total COGS? If the Operating expense is $3000, what is the break-even units? What does this mean for the company?