Income Statement Ratio Analysis

The Balance Sheet and the Statement of Income are essential, but they are only the starting points for successful financial management. Apply Income Statement Ratio Analysis to Financial Statements to analyze the success, failure, and progress of your business.

 Ratio Analysis enables the business owner/manager to spot trends in a business and to compare its performance and condition with the average performance of similar businesses in the same industry. To do this compare your ratios with the average of businesses similar to yours and compare your own ratios for several successive years, watching especially for any unfavorable trends that may be starting. Ratio analysis may provide the all-important early warning indications that allow you to solve your business problems before they destroy your business.

The following important State of Income Ratios measure profitability:

Gross Margin Ratio

This ratio is the percentage of sales dollars left after subtracting the cost of goods sold from net sales. It measures the percentage of sales dollars remaining (after obtaining or manufacturing the goods sold) available to pay the overhead expenses of the company.

Comparison of your business ratios to those of similar businesses will reveal the relative strengths or weaknesses in your business. The Gross Margin Ratio is calculated as follows:

                                    Gross Profit

Gross Margin Ratio = _______________

                                      Net Sales

(Gross Profit = Net Sales – Cost of Goods Sold)

Net Profit Margin Ratio

This ratio is the percentage of sales dollars left after subtracting the Cost of Goods sold and all expenses, except income taxes. It provides a good opportunity to compare your company’s “return on sales” with the performance of other companies in your industry. It is calculated before income tax because tax rates and tax liabilities vary from company to company for a wide variety of reasons, making comparisons after taxes much more difficult. The Net Profit Margin Ratio is calculated as follows:

                                         Net Profit Before Tax

Net Profit Margin Ratio = _____________________

                                                Net Sales

Management Ratios

Other important ratios, often referred to as Management Ratios, are also derived from Balance Sheet and Statement of Income information.

Inventory Turnover Ratio

This ratio reveals how well inventory is being managed. It is important because the more times inventory can be turned in a given operating cycle, the greater the profit. The Inventory Turnover Ratio is calculated as follows:

                                                      Net Sales

Inventory Turnover Ratio = ___________________________

                                            Average Inventory at Cost

Accounts Receivable Turnover Ratio

This ratio indicates how well accounts receivable are being collected. If receivables are not collected reasonably in accordance with their terms, management should rethink its collection policy. If receivables are excessively slow in being converted to cash, liquidity could be severely impaired. The Accounts Receivable Turnover Ratio is calculated as follows:

 Net Credit Sales/Year

 __________________ = Daily Credit Sales

    365 Days/Year

                                                                   Accounts Receivable

Accounts Receivable Turnover (in days) = _________________________

                                                                      Daily Credit Sales

Return on Assets Ratio

This measures how efficiently profits are being generated from the assets employed in the business when compared with the ratios of firms in a similar business. A low ratio in comparison with industry averages indicates an inefficient use of business assets. The Return on Assets Ratio is calculated as follows:

                                    Net Profit Before Tax

Return on Assets = ________________________

                                         Total Assets

Return on Investment (ROI) Ratio.

The ROI is perhaps the most important ratio of all. It is the percentage of return on funds invested in the business by its owners. In short, this ratio tells the owner whether or not all the effort put into the business has been worthwhile. If the ROI is less than the rate of return on an alternative, risk-free investment such as a bank savings account, the owner may be wiser to sell the company, put the money in such a savings instrument, and avoid the daily struggles of small business  management. The ROI is calculated as follows:

                                     Net Profit before Tax

Return on Investment = ____________________

                                            Net Worth

These Liquidity, Leverage, Profitability, and Management Ratios allow the business owner to identify trends in a business and to compare its progress with the performance of others through data published by various sources. The owner may thus determine the business’s relative strengths and weaknesses.

Ratio Analysis

 The Balance Sheet and the Statement of Income are essential, but they are only the starting points for successful financial management. Apply Balance Sheet Ratio Analysis to Financial Statements to analyze the success, failure, and progress of your business.

 Ratio Analysis enables the business owner/manager to spot trends in a business and to compare its performance and condition with the average performance of similar businesses in the same industry. To do this compare your ratios with the average of businesses similar to yours and compare your own ratios for several successive years, watching especially for any unfavorable trends that may be starting. Ratio analysis may provide the all-important early warning indications that allow you to solve your business problems before they destroy your business.

 Balance Sheet Ratio Analysis

Important Balance Sheet Ratios measure liquidity and solvency (a business’s ability to pay its bills as they come due) and leverage (the extent to which the business is dependent on creditors’ funding). They include the following ratios:

Liquidity Ratios

These ratios indicate the ease of turning assets into cash. They include the Current Ratio, Quick Ratio, and Working Capital.

Current Ratios. The Current Ratio is one of the best known measures of financial strength. It is figured as shown below:

                           Total Current Assets

Current Ratio = ____________________

                        Total Current Liabilities

The main question this ratio addresses is: “Does your business have enough current assets to meet the payment schedule of its current debts with a margin of safety for possible losses in current assets, such as inventory shrinkage or collectable accounts?” A generally acceptable current ratio is 2 to 1. But whether or not a specific ratio is satisfactory depends on the nature of the business and the characteristics of its current assets and liabilities. The minimum acceptable current ratio is obviously 1:1, but that relationship is usually playing it too close for comfort.

If you decide your business’s current ratio is too low, you may be able to raise it by:

Paying some debts.

• Increasing your current assets from loans or other borrowings with a maturity of more than one year.
• Converting non-current assets into current assets.
• Increasing your current assets from new equity contributions.
• Putting profits back into the business.

Quick Ratios. The Quick Ratio is sometimes called the “acid-test” ratio and is one of the best measures of liquidity. It is figured as shown below:

                        Cash + Government Securities + Receivables

Quick Ratio = _________________________________________

                                      Total Current Liabilities

The Quick Ratio is a much more exacting measure than the Current Ratio. By excluding inventories, it concentrates on the really liquid assets, with value that is fairly certain. It helps answer the question: “If all sales revenues should disappear, could my business meet its current obligations with the readily convertible `quick’ funds on hand?”

An acid-test of 1:1 is considered satisfactory unless the majority of your “quick assets” are in accounts receivable, and the pattern of accounts receivable collection lags behind the schedule for paying current liabilities.

Working Capital. Working Capital is more a measure of cash flow than a ratio. The result of this calculation must be a positive number. It is calculated as shown below:

Working Capital = Total Current Assets – Total Current Liabilities

Bankers look at Net Working Capital over time to determine a company’s ability to weather financial crises. Loans are often tied to minimum working capital requirements.

A general observation about these three Liquidity Ratios is that the higher they are the better, especially if you are relying to any significant extent on creditor money to finance assets.

Leverage Ratio

This Debt/Worth or Leverage Ratio indicates the extent to which the business is reliant on debt financing (creditor money versus owner’s equity):

                               Total Liabilities

Debt/Worth Ratio = _______________

                                  Net Worth

Generally, the higher this ratio, the more risky a creditor will perceive its exposure in your business, making it correspondingly harder to obtain credit.

Locating Reducible Expenses

Your profit and loss (or income) statement provides a summary of expense information and is the focal point in locating reducible expenses. Therefore, the information should be as current as possible. As a report of what has already been spent, a P and L statement alerts you to expense items that bear watching in the present business period. If you get a P and L statement only at the end of the year, you should consider having one prepared more often. At the end of each quarter might be often enough for some firms. Ideally, you can get the most recent information from a monthly P and L.

Regardless of the frequency, for the most information two P and L statements should be prepared. One statement should report the sales, expenses, profits and/or loss of your operations cumulatively for the current business year to date. The other should report on the same items for the last complete month or quarter. Each of the statements should also carry the following information:

(1) this year’s figures and each item as a percentage of sales.

(2) last year’s figures and the percentages.

(3) the difference between last year and this year – over or under.

(4) budgeted figures and the respective percentages.

(5) the difference between this year and the budgeted figures – over and under.

(6) average percentages for your line of business (industry operating ratio) when available, and

(7) the difference between your annual percentages and the industry ratios – under or over.

This information allows you to locate expense variation in three ways: (1) by comparing this year to last year, (2) by comparing expenses to your own budgeted figures, and (3) by comparing your percentages to the operating ratios for your line of business. The important basis for comparison is the percentage figure. It represents a common denominator for all three methods. When you have indicated the percentage variations, you should then study the dollar amounts to determine what line of operative action is needed.

Because your cost cutting will come largely form variable expenses, you should make sure that they are flagged on your P and L statements. Variable expenses are those which fluctuate with the increase or decrease of sales volume. Some of them are: advertising, delivery, wrapping supplies, sales salaries, commissions, and payroll taxes. Fixed expenses are those which stay the same regardless of sales volume. Among them are: your salary, salaries for permanent non-selling employees (for example, the bookkeeper), depreciation, rent, and utilities.

Taking Action

When you have located a problem expense area, the next step obviously is to reduce that cost so as to increase your profit. A key to the effectiveness of your cost-cutting action is the worth of the various expenditures. As long as you know the worth of your expenditures, you can profit by making small improvements in expenses. Keep an open eye and an open mind. It is better to do a spot analysis once a month than to wait several months and then do a detailed study. Take action as soon as possible. You can refine your cost-cutting action as you go along.

Reducing Costs by Analyzing Records

 Increasing profits through cost reduction must be based on the concept of an organized, planned program. Unless adequate records are maintained through a proper accounting system, there can be no basis for ascertaining and analyzing costs. One of the key values in having good record keeping (especially financial) is in reducing costs by analyzing records generated by the systems you have developed – No GIGO.

 Cost reduction is not simply attempting to slash any and all expenses unmethodically. The owner-manager must understand the nature of expenses and how expenses inter-relate with sales, inventories, cost of goods sold, gross profits, and net profits.

 Cost reduction does not mean only the reduction of specific expenses.

 You can achieve greater profits through more efficient use of the expense dollar. Some of the ways you do this are by increasing the average sale per customer,  by getting a larger return for your advertising and sales promotion dollar, and by improving your internal methods and procedures.

 Remember…. “A large and increasing sales volume often creates the appearance of prosperity while behind-the-scene expenses are eating up the profit.”

 Paying The Right Price

Your goal should be to pay the right price for prosperity. Determining that price for your operation goes beyond knowing what your expenses are. Reducing expenses to increase profit requires you to obtain the most efficient use of the expense dollar.

Look, for example, at the payroll expense.

 An understanding of the worth of each expense item comes from experience and an analysis of records. Adequate records tell what has happened. Their analyses provide facts, which can help you, set realistic goals, you are paying the right price for your operation’s prosperity.

Analyze Your Expenses

Sometimes you cannot cut an increase item. But you can get more from it and thus increase your profits. In analyzing your expenses, you should use percentages rather than actual dollar amounts.

 For example, if you increase sales and keep the dollar amount of an expense the same, you have decreased that expense as a percentage of sales. When you decrease your cost percentage, you increase your percentage of profit.

 On the other hand, if your sales volume remains the same, you can increase the percentage of profit by reducing a specific item of expense. Your goal, of course, is to do both: to decrease specific expenses and increase their productive worth at the same time.

 Before you can determine whether cutting expenses will increase profits, you need information about your operation. This information can be obtained only if you have an adequate recordkeeping system. Such records will provide the figures to prepare a profit and loss statement (preferably monthly for most retail businesses), a budget, break-even calculations, and evaluations of your operating ratios compared with those of similar types of business.

 Break-even

A useful method for making expense comparisons is break-even analysis. Break-even is the point at which gross profit equals expenses. In a business year, it is the time at which your sales volume has become sufficient to enable your over-all operation to start showing a profit.

 Once your sales volume reached the break-even point, your fixed expenses are covered. Beyond the break-even point, every dollar of sales should earn you an equivalent additional profit percentage.

 It is important to remember that once sales pass the break-even point, the fixed expenses percentage goes down as the sales volume goes up. Also the operating profit percentage increases at the same rate as the percentage rate for fixed expenses decreases – provided, of course, that variable expenses are kept in line

Understanding Financial Analysis

Efforts at Understanding Financial Analysis can lead to conflicting conclusions derived from identical facts. Comparing gross profit with the industry average could raise questions.

 If the company were more competitive in its pricing, could it capture a larger market share? A reasonable answer to this question would depend upon thorough knowledge of their operations and the experience of their sales personnel in dealing with specific customers.

 On the other hand, if their gross profit percentage is below that of the industry, a number of other questions would be raised, such as the following:

• Are they purchasing at prices that are too high to provide an adequate gross profit?
• Is their pricing structure so low that adequate gross profit margins cannot be attained?
•  Are salesmen too quick to cut prices?
•  Is their marketing effort too heavily concentrated in those product lines that offer a relatively low gross profit percentage?
•  Is their marketing effort directed toward those high-volume accounts that are so highly competitive that gross profit must be trimmed to an unrealistically low level?