ABOUT FINANCIAL RATIO ANALYSIS

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1 ABOUT FINANCIAL RATIO ANALYSIS Over the years, a great many financial analysis techniques have developed. They illustrate the relationship between values drawn from the balance sheet and income statement as ratios and are usually more informative than using dollar amounts. Ratio analysis is a very useful tool for analyzing the performance and condition of a business. It is often used to provide information that goes into a business plan; and is used to make a brief analysis of the financial condition of the business. Financial ratio analysis enables the small business owner to gauge the businesses financial weaknesses and strengths and take the appropriate action. It also allows you to compare the performance of your company with that of similar businesses in your industry. Financial ratio analysis will generally measure two areas within a company: liquidity (the amount of liquid assets your business has at any given time to meet accounts or notes payable) and profitability (the ability of the business to generate revenues, net income and an acceptable return on investment). Ratios can be expressed in a number of forms. For example, if sales are $50,000, and net income for the same period is $5,000; the ratio may be expressed in the following ways: the ratio of sales to net income is 10 to one (10:1); for $1 of sales the business has a net income of $.10; net income is 1/10 of sales; net income is 10% of sales; and net income is.10 of sales. Operating ratios calculated on a continuous basis will serve to identify trends "red flags" regarding problem areas. Try to obtain industry data to make comparisons and derive your successes compared to the industry average. Measuring profitability can be computed either before or after taxes, depending on the purpose of the computations. Do not assume, however, that ratios and ratio analysis will tell you everything you need to know about the financial performance of your business; they won t. Ratios provide a great deal of illumination, but they do have their limitations; those limitations are: Since the information used to derive ratios is itself based on accounting rules and personal judgment as well as facts, the ratios cannot be considered absolute indicators of a firm's financial position. Also, not all businesses are the same; when comparing ratios with industry averages, keep in mind that many business people prepare their financial statements differently from others resulting in financial ratios that may not present an accurate accounting of the average business in your industry. Finally, ratios are developed for specific periods; therefore, if you operate a seasonal business, ratios may not provide an accurate measure of financial performance. Ratios are based on a company s past performance; they don t necessarily offer any indication of present or future performance. Even though financial ratio analysis has their limitations, they will be of great help to you in managing your financial situation. Just keep in mind that ratios are only a means of assessing the performance of the firm and must be considered in perspective with many other measures. They should be used as a point of departure for further analysis and not as an end in themselves. A number of organizations publish financial ratios for various businesses, among them Robert Morris Associates, Dun and Bradstreet, and Statistics Canada. Your own trade association may also publish such studies. Remember, these published ratios are only averages. You probably want to be better than average.

2 There are nine key business ratios that can be calculated using data from the projected business balance sheet and income statement. They are used to calculate the profitability of a business; to make comparison from period to period; comparisons with other businesses and industries; and measure solvency. Described on the following pages, you are shown how they are calculated and given. However, having calculated these ratios you may well be asking: What do I do now? What do the ratios mean? What do you compare them to? How do you interpret a change in ratios from one year to the next? In some provinces and states, statistical organizations gather and publish data on these key ratios for companies so that year-to-year comparisons can be made and trends plotted. Keep in mind that these are projected ratios. Ratio calculation and analysis to be used properly is based on past or historical data to help identify present strengths and weaknesses of a company. After your first year of operation, you will have sufficient data to calculate the ratios and compare them to the projected ratios calculated below. This comparison will allow you to make a professional assessment as to the operations of your business. MEASURES OF LIQUIDITY / WORKING CAPITAL The various measures of liquidity / working capital will tell you how much cash on hand you have, the amount of assets that you can readily turn into cash, and generally how quickly you can do so. Liquidity is very important because it reflects the ability of a business to pay its indebtedness. A good rule of thumb for determining your financial health is the more liquid you are, the better. Perhaps the best known ratio analysis is the current ratio, quick ratio and inventory turnover ratio. They are described as follows: Current ratio The current ratio is simply the ratio of your current assets to your current liabilities or (current assets divided by current debts) and is a measure of the cash or near cash position (liquidity) of the firm. You can find your current assets and current liabilities on your balance sheet. It tells you if you have enough cash (current assets) to pay your firm's current creditors (current liabilities). It is a measure of short- term solvency. It is also called the working capital ratio. The higher the ratio, the more liquid the firm's position is, and hence the higher the creditability of the firm. Current assets normally include cash, marketable securities, accounts receivable and inventories. Naturally, you need to be realistic in valuing receivables and inventory for a true picture of your liquidity, since some debts may be non-collectible and some stock obsolete. Current liabilities consist of accounts payable, short term notes payable, and accrued expenses. Current liabilities are those, which must be paid in one year. The formula for calculation is: " Current Assets / Current Liabilities ". By rule of thumb the current ratio should be 2 to 1 (2:1 or 200% or 2$ to $1). Normally 150% is satisfactory and under 100% is not satisfactory. The higher it is, the better the indication, but the actual quality and management of assets must be considered. A general rule of thumb is that a current ratio of 2-1 could be considered satisfactory for a typical manufacturing business. Service firms typically have a lower ratio since they tend to have fewer

3 inventories. If your current ratio trend is up, it is favorable. If the trend is down, it is unfavorable. Too high a ratio can indicate the business is not utilizing its cash and other liquid assets very efficiently; while too low a ratio may raise questions about the firms ability to meet its short-term obligations. In actual practice, however, what is more important than the absolute level of the current ratio is how the ratio is changing over time. An improving current ratio would tend to indicate improved short-term financial solvency unless the business is building up excessive or obsolete inventories. You can compare your current ratio with those of similar companies within your industry by referring to surveys conducted by various trade associations and marketing companies. If you feel your current ratio is too low after you evaluate it and compare it to the industry average, you may be able to increase it in a number of ways. You can increase your current ratio by paying off some of your debts that appear as current liabilities, or by turning some of the fixed assets or miscellaneous assets into current assets. As a last resort you may have to funnel profits back into the business. Quick ratio Like the current ratio, the quick ratio or referred to as the (acid-test ratio) also measures the liquidity of your business. This ratio is a refinement of the current ratio and is a more conservative measure of liquidity. The quick ratio is found by dividing all your liquid assets called quick assets by current liabilities. Quick assets are current assets minus inventory. Quick assets are highly liquid - those which are immediately convertible to cash (they are cash on hand and any government securities). The purpose, again, is to test the firm's ability to meet its current obligations. The quick ratio indicates the extent to which a company could pay current debt without relying on future sales. This test doesn't include inventory to make it a stiffer test of the company's liquidity. It tells you if the business could meet its current obligations with quickly convertible assets should sales revenues suddenly cease. The quick ratio can be used to estimate the ability of the firm to pay off its short-term obligations without having to sell its inventory. Inventories tend to lose their value faster than other assets if disposed in a hurry. The quick ratio is probably a more valid test of the firms ability to meet its current liabilities and pay its bills than the current ratio. The formula for calculation is: " (Current Assets - Inventory) / Current Liabilities ". By rule of thumb, the ratio should be 1 to 1 (1:1 or 100% or 1$ to 1$). If below 80-90% you probably have liquidity problems. If well above 100% you may have an unfavorable balance between strong and weak earning current assets and further analysis may show that there are excessive accounts receivable which may require a reevaluation of the credit and collection policy of the business, it could also reflect an ineffective use of cash. If the quick ratio trend is up and not much above 100% it is favorable. If the ratio trend is down it is unfavorable, because the company may be undercapitalized and more investment may be necessary or business debt should be restructured to reduce the amount of monthly debt servicing.

4 The quick ratio is a measure of exactly where you would be if you faced a crisis and had no way to correct your financial position. Try to keep your quick ratio at a level sufficient for your needs. Remember, good financial management allows the best use of your assets and increases the profitability of your business. If you have cash and inventories that exceed your needs and are lying idle, you are not using them to your greatest advantage. You have to walk a tight rope between much liquidity and not enough liquidity. MEASURES OF PRODUCTIVITY & DEBT Productivity and debt ratios are an indication of small business management efficiency and effectiveness. They provide the basis for examining various aspects of the business by combining both balance sheet and income statement information. Debt to equity ratio The debt to equity ratio compares the amount invested in the business by creditors with that invested by the owner(s). The ratio indicates the firms obligations to its creditors relative to the owners level of investment in the business. This ratio is an indication of leverage, reflecting your financial stability. This ratio is a measure of how the company can meet its total obligations from equity. The higher the ratio, the greater the risk being assumed by creditors. The lower the ratio, the higher the proportion of equity relative to debt and the better the firm's credit rating will be. This ratio is found by: (adding current debt and long term debt and diving by total equity). Debt includes current liabilities, long term loans, bonds and deferred payments. The owners equity includes the value of common stock, or cash and assets contributed. The formula for calculation is: " (Current Debt + Long Term Debt) / Total Equity ". This ratio indicates financial stability and the lower the better. A ratio greater than one means the firm is using more debt than equity to finance investments. The higher the ratio, the more the creditors claim and possibly indicating that the business is extending its debt beyond its ability to repay. If the debt to equity ratio trend is up, it is unfavorable. If the ratio trend is down it is favorable and the firm will have greater flexibility to borrow in the future. However, an extremely low ratio may indicate that the owner is too conservative and is not letting the business realize its potential. Accounts receivable collection period This ratio is helpful in analyzing the collection ability of the receivables, and the efficiency of your credit and collection system. This ratio tells you the length of time it takes the firm to get its cash after making a sale on credit. It should be looked at in relation to the allowable credit period you have established. For example if you have extended credit for a period of 30 days, your ratio should be very close to that same number of days. As a rough rule of thumb, the collection period should not exceed days longer than the maturity period of your credit deadline. For example if your terms were net 30 days, the ratio should not exceed days. This extra time allows for mail delays and processing time. The shorter this period the quicker the cash inflow is. A longer than

5 normal period may mean overdue and uncollectable bills. This ratio also provides some indication of the quality of the receivables, and also an idea of how successful the firm is collecting its outstanding receivables. Generally, the greater number of days outstanding, the greater the probability of delinquencies in accounts receivable resulting in bad debt. If your ratio is much longer than the established period, you may need to alter your credit policies. It's wise to develop an ageing schedule to gauge the trend of collections and identify slow payers. Slow collections (without adequate financing charges) hurt your profit, since you could be doing something much more useful with your money, such as taking advantage of discounts on your own payables. The formula for calculation is: " Accounts Receivable / (Total Sales / 365 Days) ". If the average collection period ratio trend is up, it is unfavorable; and means you are financing your customers and acting as their bank, and the older the accounts receivable, the harder it is to collect. This can have very negative effects on the management of your business and the profit potential. You could be paying high debt servicing rates at the bank for the money that you are in effect lending to your customers. It could also limit the volume discount purchases that you can make from suppliers to increase your profit line, because you are stretched in your line of credit at the bank. If the ratio trend is down it is favorable and it is a sign that you are becoming more efficient in your credit and collection policies. If it is less than the published collection period for the industry, it usually means your collection policy is particularly effective. If your ratio is substantially below the industry average, it may mean that you are loosing sales and you may have a credit policy that is too stringent. Inventory turnover The purpose of this ratio is to show the number of times inventory is sold and replaced over a given period. This will provide you with a measure of the amount of capital you invest in inventory to meet your operational requirements; how quickly inventory is sold; and the efficiency of funds invested in materials and inventory; how often inventory is liquidated and the quality of the inventory. This ratio is important in showing how efficiently the inventory is being managed by determining the investment to be made in inventory, and maintaining a watch on dated stock. The aim here is to maintain and increase sales while inventory is reduced or at least maintained. The formula for calculation is: " Total Cost of Goods Sold / Average Inventory on Hand ". A high turnover rate indicates efficient management, and the ability to turn inventory to cash quickly and superior merchandising. Conversely it can also indicate a shortage of needed inventory for sales and poor assortments. If the trend is down, it is unfavorable. This can indicate poor liquidity, possible overstocking, obsolescence, or in contrast to these negative interpretations a planned inventory buildup in the case of material shortages. If inventory turnover is low, it could signal a number of factors: sales volume has declined; some of the inventory is damaged or dated and therefore difficult to sell; or if temporary, the firm has stocked up in anticipation of increased sales for Christmas. A high or increasing rate of inventory turnover generally means that inventory is well managed. A turnover rate that is too high may mean that inventory is being kept to low,

6 which could cause a crucial shortage of stock if there is an insufficient number of major items in inventory. In addition, insufficient stocking may not permit you to present and extensive enough or interesting enough assortment of products for your customers. If your ratio deviates considerably from industry standards, it may indicate poor marketing as well as poor management. If you are selling perishable goods, it is of course necessary that your inventory turnover rate is very high or you will be suffering a high spoilage rate and consequent loss in profits. Operating expense ratio This ratio will assist you in telling how well you are controlling expenses. It will assist you to evaluate internal economic efficiency. For example, if you compare this ratio with a budgeted expense figure developed at the beginning of your year. You can see if your expenses compare with your projections. If so, there should be little discrepancy between the two figures. It also indicates the trend of your expenses. Operating expense can be calculated by the total operating expense amount or by separately dividing each operating expense such as salaries, or wages, by total sales. From the resulting picture, owners evaluate internal economic efficiency, and gain valuable management information. The formula for calculation is: Total Expenses / Total Sales ". This ratio should be compared to your budget. It should be on budget. If lower than industry norms this is considered favorable. If the operating expense ratio is up, it is unfavorable; profits are being eroded because expenses are too high. If the ratio trend is down this is favorable, costs are being controlled. PROFITABILITY MEASURES Throughout your businesses lifetime, you will rely on your business for several things. Making money of course is the highest priority. After all, it is the reason you went into business in the first place. If your business is not profitable, why put yourself through the headaches and long hours that usually come with owing your own business. You could work for someone else secure in the knowledge you will receive a weekly paycheck, benefits and more free time. Making money is what being in business is all about. This section discusses several methods that measure just how profitable your business is. Profitability measures are: gross profit margin, net profit margin, return on investment, breakeven analysis. Using these profitability measures you will learn how much money you are making, whether you are using your present resources to maximize the profit potential of your business, and whether you are losing money or just breaking even. Gross profit margin The purpose of this ratio is to determine the percentage of gross profit on each sales dollar. It reveals the actual percentage of sales revenue available to cover operating and general expenses, wages and taxes, and provide a profit. If you compare your gross profit with your average desired markup, you can see the effect of discounts and theft or

7 spoilage on your business operation. If your ratio is different than your budgeted ratios, you will want to examine the reasons for this very carefully. The gross margin ratio is the amount of sales dollars available after subtracting direct costs such as labor and materials (inventory) to cover both fixed and variable operating expenditures on a daily, monthly or annual basis. The formula for calculation is: " Total Gross Margin / Total Sales ". A higher than average number is desired. If the gross margin ratio trend is up, it is favorable. If the trend is down it is unfavorable; it may mean that your markup is too low or you are paying too much for your merchandise. The solution among others is to increase sales, decrease costs and increase your markup. Net profit margin This ratio allows you to determine the percentage of net profit on each sales dollar. Net profit on sales is one of the most common ratios used to determine the profitability of a business. It measures the difference between your net sales and what you spend to operate your business. The net profit ratio measures managements ability to control expenses, pay taxes, and result in a reasonable profit margin on sales. Operating expenses kept under control through efficient management will result in a constant ratio over several years. The formula for calculation is: " Net Profit Before Tax / Total Sales ". If the owners salary is a fair management fee, the ratio will show the average percentage of net profit in each sales dollar. The higher this ratio is, generally the better. If the net profit ratio trend is up, it is favorable. If the ratio trend is down it is unfavorable, and you should look at your mark up policy and expenses. Most experts agree that if your ratio of net profit to sales does not exceed the amount of money that you could earn from interest or dividends in securities then you are not utilizing your assets to your best advantage. Check the average ratios of similar businesses with your industry and compare your net profit on sales against theirs. If your net profit on sales is substantially lower, you should re-evaluate the areas in your business that could reduce your earning power. Those areas might be high operating costs, high shrinkage, or a price point that may not produce sufficient profit or which might not be competitive enough. Breakeven sales analysis The breakeven analysis is important when you are in the planning stages of your business start up. The breakeven analysis tells you how much money you need to make in sales, daily, weekly or monthly to pay all of your expenses. The point at which all costs have been accounted for and profits begin to occur is the breakeven point. In assessing the breakeven point, you are really trying to ascertain how low sales can be before you go out of business. By preparing the breakeven analysis, you are showing the lender that you have anticipated the worst, and that you will know when your business is in trouble. Once calculated, the breakeven point should represent the minimum acceptable sales level for the first year. It is a floor; and if sales drop below this level you will be loosing

8 money. Once sales exceed the breakeven point, you begin to make a profit. The lower you keep your breakeven, the less vulnerable you are. This figure is important when you are trying to decide whether your business will survive its first (and usually most difficult) year. It is a signal that warns you of the risk you may be taking. Breakeven sales are calculated by dividing total expenses (including loan principal payments & depreciation) by the average projected gross margin % obtained from all sales categories. The formula for calculation is: Total Expenses / Gross Margin. Return on owner s investment The Return on owners investment (ROI) is the most common ratio used to determine a businesses profitability. It helps determine the adequacy of owners investment plus the effectiveness of its use. In other words, the return on investment ratio measures the earning power of the capital that you have invested in your business. It is an overall indicator of the strength of your business. It is an indication on the rate of return on the money you will have invested in your business; and should be compared to the rate of return you might expect on your money if invested elsewhere. It focuses on the profitability of the overall operation of the firm. Thus, it allows management to measure the effects of its policies on the firm's profitability. The ROI is the single most important measure of a firm's financial position and you might say it's the bottom line for the bottom line. ROI is expressed as a percentage so that it can be compared with other possible avenues of investment you might be considering. It represents a monetary or dollar factor. In comparing an investment in your own business with investing in someone else s enterprise (e.g. buying stocks or bonds, becoming a silent partner, etc.), there are factors other than monetary to be considered such as personal independence, challenge, security, and responsibility. There are several ways to determine ROI, but the easiest and most popular is to divide net profit by total owners equity. The formula for calculation is: " Net Income After Tax / Total Owners Equity ". To calculate this for year two and year three, add the net profit after tax for year one to the owners investment and follow the above calculation. If the return on investment ratio trend is up, it is favorable, since the ratio provides an overall barometer of the business. If the ratio trend is down it is unfavorable. A decline indicates problems and you have to ask yourself if you are getting sufficient return on your investment to be worthwhile. Keep in mind that the return on investment is not necessarily the same as profit. ROI deals with the money you as an owner invest in the restaurant and the return you realize on that money based on the net profit of the business. Profit on the other hand measures the performance of the business. You can use ROI to measure the performance of your pricing policies, your inventory investment and so forth. RATIO CALCULATION FORMULAS

9 Ratio Calculation Cost of Goods Sold (%) Total Cost of Goods Sold $ / Total Sales $ Gross Margin (%) Total Gross Margin $ / Total Sales $ Total Expenses to Sales (%) Total Expense $ / Total Sales $ Net Profit Before Tax to Sales (%) Net Profit Before Tax $ / Total Sales $ Current Ratio Quick Ratio Accounts Receivable Collection Sales to Equity Fixed Assets to Equity Current Debt to Equity Total Debt to Equity Return on Investment Before Tax Current Assets / Current Liabilities (Current Assets- Inventory) / Current Liabilities Period (Days) Accounts Receivable / (Total Sales / 365 Days) Total Sales / Total Equity Total Assets / Total Equity Current Liabilities / Total Equity (Current Debt + Long Term Debt) / Total Equity Net Income Before Tax / Total Assets Return on Owners Equity Before Tax Net Income Before Tax / (Total Equity + Shareholder Loans) Plan Sales Volume Breakeven Sales Volume Planned Sales Volume Total Expenses (incl. depreciation) + LC Interest + Loan Principal Payments / Gross Margin % Average Monthly Breakeven Breakeven Sales Volume / 12 Sales Volume Inventory Turnover (Times) Total Cost of Goods Sold $ / Average Inventory

10 OTHER INFORMATION Other information includes topics on: Critical issues in manufacturing, retail & service industry Tips for buying an existing business Wholesalers / suppliers support services How to achieve customer satisfaction Effective merchandising techniques The importance of an effective sales force Selling on consignment Letters of credit

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