ABOUT FINANCIAL RATIO ANALYSIS

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.

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

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.

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 10-15 days longer than the maturity period of your credit deadline. For example if your terms were net 30 days, the ratio should not exceed 40-45 days. This extra time allows for mail delays and processing time. The shorter this period the quicker the cash inflow is. A longer than

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,

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