Last month, we launched a series of articles focusing on a process called Profit Mastery—the art of taking control of your business destiny.As a business owner or manager, you’re plagued by the conflict of multiple roles and limited time. You wear a series of different hats and juggle several “management” balls at the same time. But the one hat you can never shed is that of financial manager and planner. You can’t take it off, and you can’t give it away. In fact, when you finally have an accounting system that produces timely and accurate financial statements, it marks the beginning of your primary ownership responsibility: understanding and interpreting exactly what it is you have.
Analyzing your statements is an unglamorous task, and the only way to start is to roll up your sleeves and dig in. It’s a three-step process: First, understand how your statements are formulated—that is, their structure and composition; second, use your data to produce a series of financial ratios to measure performance; and third, interpret the information, using the ratios, to analyze the causes and effects of financial events in your company.
The last article discussed the two key yardsticks of financial performance—the balance sheet and the income statement. Taken together, they represent as complete a financial picture of your company as it’s possible to get. Now, it’s a common practice (and a sensible one) for businesses to have at least two—sometimes three—sets of financial statements: one for the IRS (with the tax rules and regulations making net profit look as small as possible), one for your banker (adjusted to present the most glowing picture of the business), and one for yourself. But remember, you can’t fool all of the people all of the time. And the worst person to kid is yourself. You need clear, concise, decision-relevant information.
Incidentally, two or three sets of statements does not imply two or more sets of books—the general journal and the general ledger, which report all financial events that occur in the business. Having more than one set of books implies falsifying financial transactions—and that’s a good way to go straight to jail, courtesy of the IRS. On the other hand, a company’s financial statements put the information from the books into a format that is influenced by the purpose for which the statements are being developed.
With a management decision-making goal in mind, let’s take your financial information and develop a set of measurements that will allow us to monitor both your current position and your progress. We’ll do this by developing a series of financial relationships, or ratios.
Remember, a ratio is nothing more than one number in relation to another. However, ratios are practical because they can reduce a relationship to one number no matter the size of the two numbers involved. For example, the ratio of 2:1 can be derived from numbers 20 divided by 10, 200 divided by 100, or 200,000 divided by 100,000. The ratio doesn’t care about the absolute size, it only cares about the relationship. And it’s this relationship that will be used to measure and manage your financial effectiveness.
Picking and choosing. Which relationships should you measure? There are many possibilities, and each financial analyst will have his or her own preferences. I have chosen to use the K.I.S.S. (Keep it Simple, Steve!) method—enough to get the job done, but not so much as to become confusing. The chart on pages 100 and 102 has three basic parts: the name of the ratio, how it’s derived, and what it measures. (Next month, I’ll address the key point: namely, why would anyone in his right mind do this?)
First, you’ll need three years of financial statements, or as many as you have. Second, lay out your statements in a spreadsheet format, which is nothing more than putting all the financial data on one sheet, side-by-side, by year. Third, use the same spreadsheet format to calculate your financial ratios.
Take a few minutes to read and study the ratios, including how they’re derived and what they measure. Note that the ratios are broken down into three areas: balance sheet ratios, profitability ratios, and asset management ratios. We want to develop financial “balance”—no single ratio tells the entire story. Taken together, however, they can help you analyze your performance and plan for the future.
Putting the numbers to work. You operate and manage your firm with limited resources, management, capital, and time. You can’t fix current problems or spot developing ones unless you know where to look. The “Profit Mastery” process is an efficient, effective method to keep your finger on the pulse of your company.
In general, there are three ways to use these ratios to analyze your business: to compare your current performance to your performance in prior years (trends); to compare your present performance to others in your industry (next time, I’ll provide some industry figures); and to compare your ratios to your plans in developing a workable operating strategy.
Of course, the ratios are of no use unless you can decipher the numbers. Note that in each box, I’ve shown what the ratio means in plain English. Here’s a handy sentence you can use to interpret most ratios:
“For every $1 of [the bottom part of the ratio], there is $X of [the top part of the ratio].”
For example, a current ratio (current assets divided by current liabilities) of .99 means: For every $1 of current liabilities, there is 99 cents of current assets. In other words, for every dollar the business has to pay out in the coming 12 months, there is 99 cents available to pay for it. This ratio measures a company’s ability to pay its bills.
In next month’s article, we’ll take the next logical step and answer two questions: How can these numbers help us make better decisions for the future? What type of numbers will the local bank want to see? In the meantime, your assignment is to give yourself a Profit Mastery checkup and begin to digest the information.
Do you have an issue that’s related to the numbers side of your company? Send it in—we’ll be sharing our responses to the most-asked questions in future articles.
Financial ratios
HOW TO CALCULATE | WHAT IT MEANS IN DOLLARS AND CENTS | |
BALANCE SHEET RATIOS | ||
Solvency and Liquidity Ratios | ||
Current Ratios | Current Assets/Current Liabilities | Measures solvency: the company’s ability to pay its bills. |
Quick Ratio (or acid test ratio) | Cash + Accts Rec./Current Liabilities | Measures liquidity: the company’s ability to pay its bills without relying on the sales of inventories. For example, a quick ratio of 1.14 means that for every $1 of current liabilites, the company has $1.14 in cash and accounts receivable with which to pay them. |
Safety Ratio | ||
Debt-to-Net Worth | Total Liabilities/Net Worth | Measures the company’s ability to withstand adversity; shows the riskiness of the firm. For example: a debt-to-worth ratio of 1.05 means that for every $1 of net worth that the owners have invested, the company owes $1.05 of debt to its creditors. |
PROFITABILITY RATIOS | ||
Gross Margin Ratio | Gross Profit/Sales | Measures the percentage of each dollar left after deducting the cost of the goods sold. For example: a gross margin ratio of 48% means that for every $1 of sales, the company produces 48 cents of gross margin. |
Net Margin Ratio | Net Profit Before Tax/Sales | Measures the percentage of each sales dollar left after deducting all expenses except income taxes. For example: a net margin ratio of 2.9% means that for every $1 of sales, company produces 2.9 cents of net margin. |
PRODUCTIVITY RATIOS | ||
GMROI | Gross Profit/Inventory | Measures the productivity of Inventory; the amount of gross profit generated for each dollar of inventory. For example a GMROI of 1.7 means that for every dollar of inventory the company is generating $1.70 in gross margin. |
ASSET MANAGEMENT RATIOS | ||
Sales-to-Assets | Sales | Measures the efficiency of a company’s assets in producing sales. Total Assets Shows how many sales are produced by one dollar of assets. A sales to assets ratio of 2.35 means that for every $1 invested in total assets, the company generates $2.35 in sales. |
Return on Assets | Net Profit Before Tax/Total Assets | Measures the efficiency of each dollar of assets employed by the firm at producing profits. For example, a return on assets of 7.1% means that for every dollar invested in assets, the company is generating 7.1 cents in net profit before tax. |
Return on Investment | Net Profit Before Tax/Net Worth | Measures the percentage return on each dollar invested by owners. For example, a return on investment ratio of 16.1% means that for every $1 invested in net worth, the company is generating 16.1 cents in net profit before tax. |
Inventory Turnover | Cost of Goods Sold/Inventory | Measures the annual rate at which the inventory is being sold. For example, an inventory turnover ratio of 1.7 means that average dollar volume of inventory is used up almost 10 times during the year. |
Inventory Turn Days | 360/ Inventory Turnover | Converts the inventory rate to “days of inventory” on hand. For example: an inventory turn days number of 211 means that the company keeps an average of 211 days of inventory on hand throughout the year. |
Accounts Receivable Turnover | Credit Sales/Accounts Receivable | Measures the rate at which accounts receivable are being collected on an annual basis. For example, an accounts receivable turnover ratio of 8 means that the average dollar volume of accounts receivable are collected eight times during the year. |
Average Collection Period | 360/A/R Turnover | Converts the accounts receivable turn ratio into the average number of days the company must wait for its accounts receivable to be paid. For example, an average collection period of 45 means it takes the company 45 days on average to collect its receivables. |
Accounts Payable | Cost of Goods Sold/Accounts Payable | A measure of the average length of time it takes the company to pay its bills. For example, an accounts payable turnover ratio of 12.04 means that the average dollar volume of accounts payable are paid about 12 times during the year. |