Quite frequently I visit with busi-ness owners who get financial state ments but don’t really use them to improve their business. Yet we all pay attention to the balance in our checking account. Wouldn’t you want to know how to improve that balance? Before we start, remember that financial statements must be analyzed in a timely fashion. Looking at something six months after it happened provides little opportunity for improvement. Next, have your Income Statement and Balance Sheet common sized. Relate each item on your income statement as a percentage of total sales. This allows you to view percentages over time as opposed to just dollar amounts.
Then look for trends. Compare your numbers from this year to those from last year. View performance by months as well, comparing this August to last August. When you see variation, ask “why”? What happened from one time period to the next to create that variation? Is the cause of that change something you can control? Here are some common ratios used to analyze financial statements.
Current ratio (= current assets / current liabilities) This ratio shows how well current assets generate the cash to cover current liabilities. A ratio of 2:1 means that for every dollar in current liabilities you have two dollars in current assets to pay off that liability. If the ratio was 1:1, you are at risk of not being able to pay your bills. When analyzing monthly statements over time, find the months when your ratio was at its highest. What was it about your operations at that time that led to such a strong number?
Quick ratio (= cash + accounts receivable / current liabilities) This ratio has removed inventory from the current ratio. It truly represents your ability to quickly pay your bills. If this ratio is less than 1:1, you should look closely at your accounts receivable. How many of them are paying as agreed? Are you at risk of having your credit cut off and stalling operations because they are not paying?
Gross Profit (= gross profit / net sales) Compare this over time and to industry standards. Remember, if you want to improve this number you can only do two things; raise prices or reduce costs. Selling more volume will not improve this number! For some businesses, the key question may be how much profit do I want out of my business rather than how much sales do I want out of my business. The business highway is littered with those who became larger and then became unprofitable.
Operating Profit (= operating profit / net sales) As above, compare this ratio over time and to industry standards. A company could have a great gross profit number and a poor operating profit ratio. This would tell you to look at your operational expenses rather than at the pricing or buying of products.
If you would like a free worksheet to help you analyze your financial statements, please contact Jim Kress at Central Oregon Community College. He can be reached at 383-7712.
Understanding Your Financial Statements,
Part Two
by JIM KRESS of COCC
In the previous edition of Cascade Business News we discussed how to ana- lyze the liquidity and profitability of your firm through your financial statements. We used the current and quick ratio along with gross profit and operating profit ration. This article will continue that discussion by focusing on operational issues. If your operating profit ratio (= operating profit / net sales) has dipped over the last few months or when comparing to the same time last year, consider looking at the following:
Average Collection Period (= 365 days / (sales/accounts receivable)) This ratio tells you how many days it takes to collect your accounts receivable. You can compare this to previous months and to the average in your industry. As the economy slows, pay close attention to your collection period. It is one of the first signs you may be headed for a cash flow problem, especially if you have accounts that you may not be able to collect from.
Inventory Turnover (= Costs of good sold / average inventory) This is another ratio you should compare to trends in business along with industry averages. Calculated in retail selling price dollars or cost dollars. Turnover is the number of times during a specific period that the average stock on hand is sold. Higher rates mean fresher merchandise, fewer markdowns, lower inventory expense, greater sales, and higher returns. However, if turns are much higher than industry average, one may be at risk of stock-outs and lose sales, increase accounting costs by processing too many orders, increase costs of transportation & handling, and possibly lose out on quantity discounts.
Advertising to Sales (= Advertising / net sales) Tells you how much of each sales dollar you plug into advertising. Each industry has a standard. If you have a bad location you should be paying less in rent but having to spend more dollars on advertising.
Wages & Benefits to Sales (= Total wages & benefits / net sales) This tells you how much of each sales dollar goes to pay employee’s wages. It allows you to compare your business to industry standards. If you pay more than your competition, your salespeople should sell more. If you pay your salespeople less, you can expect them to sell less and be closer to being a clerk than the salespeople your competitors have.
Average Ticket Value (= Sales / Number of Transactions) Measures how well individuals are selling up” by offering accessories. Also helps determine effort required per transaction.
Sales by Individual (= Individual Sales / Total Cost of Individual) Measures individual productivity. Make sure you don’t compare new employees to those with years of experience. You would expect more from those with the experience.
Sales per Man Hour (= Sales / Number of Hours Worked) Measures overall productivity and the efficiency of personnel scheduling.
Remember, ratio analysis is a process to help locate the positive efficiencies and potential problems in your firm. They don’t necessarily give you the answer. As an example, you may notice you have poor inventory turns compared to last season or the industry. The ratio tells you that. But then you must look for solutions.
Must you buy at a better price, have more frequent deliveries of smaller orders, attend buying shows to find the latest in merchandise, or shop your competition to see what they are doing better? The ratio analysis is the thermometer in evaluating your business. You’re the doctor. You still need to make the proper prescription!
If you would like a free worksheet to help you analyze your financial statements, please contact Jim Kress at Central Oregon Community College. He can be reached at 383-7712.
Remember, ratio analysis is a process to help locate the positive efficiencies and potential problems in your firm. They don’t necessarily give you the answer. As an example, you may notice you have poor inventory turns compared to last season or the industry. The ratio tells you that. But then you must look for solutions.
