Balance Sheet Ratio Analysis

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

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

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

Budget Revenue Basis

Which Sales Method for establishing your budget revenue basis?

Your budget revenue basis can be determined as a percentage of past sales, of estimated future sales, or as a combination of the two:

 1. Past Sales. Your base can be last year’s sales or an average of a number of years in the immediate past. Consider, though, that changes in economic conditions can make your figure too high or too low.

 2. Estimated future sales. You can calculate your advertising budget as a percentage of your anticipated sales for next year. The most common pitfall of this method is an optimistic assumption that your business will continue to grow. You must keep general business trends always in mind, especially if there’s the chance of a slump, and hardheadedly assess the directions in your industry and your own operation.

 3. Past sales and estimated future sales. The middle ground between an often conservative appraisal based on last year’s sales and a usually too optimistic assessment of next years is to combine both. It’s a more realistic method during periods of changed economic conditions. It allows you to analyze trends and results thoughtfully and to predict with a little more assurance of accuracy.

 Unit of Sales

In the unit-of-sale method you set aside a fixed sum for each unit of product to be sold, based on your experience and trade knowledge of how much advertising it takes to sell each unit. That is, if it takes two cents’ worth of advertising to sell a case of canned vegetables and you want to move 100,000 cases, you’ll probably plan to spend $2,000 on advertising them. Does it cost X dollars to sell a refrigerator? Then you’ll probably have to budget 1,000 time X if you plan to sell a thousand refrigerators. You’re simply basing your budget on unit of sale rather than dollar amounts of sales.

 Some people consider this method just a variation of percentage-of-sales. Unit-of-sales does, however, probably let you make a closer estimate of what you should plan to spend for maximum effect, since it’s based on what experience tells you it takes to sell an actual unit, rather than an overall percentage of your gross sales estimate.

 The unit-of-sales method is particularly useful in fields where the amount of product available is limited by outside factors, such as the weather’s effect on crops. If that’s the situation for your business, you first estimate how many units or cases will be available to you. Then, you advertise only as much as experience tells you it takes to sell them. Thus, if you have a pretty good idea ahead of time how many units will be available, you should have minimal waste in your advertising costs.

 This method is also suited for specialty goods, such as washing machines and automobiles; however, it’s difficult to apply when you have many different kinds of products to advertise and must divide your advertising among these products. The unit-of-sales method is not very useful in sporadic or irregular markets or for style merchandise.

Understanding Financial Analysis

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?

Analyzing Current Sales and Gross Profit

Analyzing Current Sales and Gross Profit

Your sales and gross profit forecast begins with analysis of current performance. Sales are usually divided into various categories. Each category is examined individually to determine expected sales for the coming year. Time spent Analyzing Current Sales and Gross Profit will help you manage your business and allow you to be proactive in changes to your business model.

 

Selecting Sales Categories

The selection of categories will depend upon the nature of your business. For example, a food broker selling to a large number of relatively small accounts might be interested primarily in analyzing sales by product. The owner of a single retail store might choose to analyze sales by selling department, while the owner of a retail chain would probably be interested in analyzing sales by outlet. An insurance broker with several agents might categorize sales by agent. An individual wholesaler might consider sales by sales territory.

 

Factors Affecting Sales

After categories have been selected and current sales divided among them, the various factors that can affect sales in each category must be considered. These factors could be either internal or external. Internal factors are those that you can influence. External factors are those that affect the market served by your business, but are generally beyond your control.

 Internal Factors

The following are typical internal factors that could influence your sales forecast:

  • Promotional plans
  • Expansion plans
  • Capacity restrictions
  • New product introductions
  • Product cancellations
  • Sales force changes
  • Pricing policy
  • Profit expectations
  • Market expansion to new customers or territories

 External Factors

Among the external factors that must be considered are the following:

  •  Business trends
  • Government policies
  • Inflation
  • Changes in population characteristics
  • Economic fortunes of customers
  • Changes in buying habits
  • Competitive pressures

Sales Forecasting and the Business Plan

Sales Forecasting and the Business Plan

Summarize the data after it has been reviewed and revised, for your goal is to integrate sales forecasting and the business plan. The summary will form a part of your business plan. The sales forecast for the first year should be monthly, while the forecast for the next two years could be expressed as a quarterly figure. Get a second opinion. Have the forecast checked by someone else familiar with your line of business. Show them the factors you have considered and explain why you think the figures are realistic.

 Your skills at forecasting will improve with experience particularly if you treat it as a “live” forecast. Review your forecast monthly, insert your actuals, and revise the forecast if you see any significant discrepancy that cannot be explained in terms of a one-time only situation. In this manner, your forecasting technique will rapidly improve and your forecast will become increasingly accurate.

 Forecasting Sales and Gross Profits

 Development of your profit plan should usually begin with a forecast of your expected sales and gross profit for the coming year.

 The sales and gross profit must be considered together since they are so closely interrelated. Gross profit percentages are determined by pricing policy, which also affects expected sales volume. A decision to increase the expected gross profit percentage will usually tend to decrease expected sales, while reducing the expected gross profit percentage should increase sales.

 A second major reason for beginning the profit plan with a sales forecast is that the volume of expected sales often determines a number of other factors such as the following:

 Expected changes in variable expenses, those expenses that tend to change in direct proportion to changes in sales.  These could include expenses such as sales commissions or delivery costs.

The impact of the added sales volume on the various fixed costs of operating your business. These costs, by definition, do not tend to vary in direct proportion to changes in sales volume. However, substantial increases in sales over an extended period can force an increase in many fixed expenses. For example, a sales increase realized through the addition of many new accounts could affect bookkeeping and credit costs.

The ability of present resources such as storage space, display area, delivery capability, or supervisory personnel to accommodate the added volume.

The need for funds to invest in increased inventory or accounts receivable to accommodate sales increases.

Cash generated from operations to meet current operating needs as well as expansion requirements, debt repayments, and owners’ compensation.

 Realism

A realistic sales forecast must rely on careful analysis of market potential and the ability of your business to capture its share of this potential. The forecast should not be based upon “what you would like to do” or “what you hope to do.” It must be “what you can do” and “what you will do.”