Go beyond the basics of learning to read and understand your financial
statements. Learn what ratio analysis can tell you about your business
and how to act on what is uncovered. Is your business in cardiac arrest? Let's find out.
Ratios on their own don't have a lot of meaning. They become a very useful tool when the calculations are compared over a number of years as trends start to become evident.
Generally there are four types of ratios that we will be looking at:
So fill up your teacup and let's get started on this quick accounting training session.
For now, let's start your accounting training with a look at your working capital and your current ratio.
Working Capital = Current Assets - Current Liabilities
(The larger this number is, the better. If it equals zero, you have no working capital.)
Current Ratio = Current Assets / Current Liabilities
(The higher this ratio is, the better. If it equals one, you have no working capital.)
These two calculations are measuring your business's liquidity. They calculate whether your business can meet their debt obligations when they become due. The more cash you have, the more likely you will be able to make it through the tough times or the next recession.
In easy to understand language, these calculations determine whether you
will be able to meet your payroll, pay your suppliers, and pay down
your loans on the agreed upon payment schedule.
As a small business owner, you can improve/manage your working capital by increasing your current assets and/or decreasing your current liabilities.
Now let's continue this accounting training by turning our attention to your accounts receivable (AR). Two useful ratios you might want to calculate are:
AR Turnover = Net Credit Sales for Year / Average AR for Year
(This number shows you the average number of times your AR turned over (collected) in a year compared to sales.)
To calculate this ratio you need two pieces of information.
Credit Sales are the sales reported on your income statement that were paid by extending credit. If you don't have the split, you can use your total sales but the calculation will not be as accurate.
To calculate your average receivables, take your AR balance at the end of last month + your AR balance at the end of the same month last year. Now divide by 2 and you have your average AR for the year.
A higher ratio infers that you are successfully collecting from
your customers ... and that you have tight credit policies ... or your
business deals mainly on a cash basis.
A lower ratio indicates problems and infers your customers are not paying you on a timely basis or overstocked inventory. You may experience cash flow crunches due to late or non payments. Also, the longer an account is outstanding, the more risk to you that it will not be collectible.
While there is no actual standard for this next operating ratio due to the unique circumstances of each business ... you can sometimes find a standard for your industry to compare against.
Days to Collect AR = 365 days / AR Turnover in Year
(This shows you the average number of days it took for your customers to pay you. As you can see, it is based on your previous calculation. If your turnover calculation is wrong, this ratio will be wrong as well.)
If your answer comes in under 30 days, then you know your customers are paying their accounts on time.
The faster you collect your receivables, the better. When customers pay you, you will be able to pay your suppliers on time or buy new product. When receivables are paid quickly and on time, there is less risk to you and your business.
If it is taking longer than 30 days for your customers to pay you, you need to take action. Your business could get in serious trouble if your accounts receivables are not actively managed. Consider implementing these collections procedures so your AR does not get away from you.
Nina Kaufman's home-study program How to Train Your Clients to Pay You can teach you how to decrease your receivables and increase your cash flow.
You might also want to calculate the bad debt to sales ratio. Simply divide your bad debt expense by your credit sales. This ratio measures your expected uncollectible AR. If it is increasing, it indicates a future write-off is possible.
Moving on in this brief accounting training session, let's turn our focus to profitability.
When learning about the various components of the income statement, we chatted about the gross profit. Sometimes this number makes more sense if it is expressed as a percentage.
We said that ...
Gross Profit = NET Sales - Cost of Goods Sold
Net Sales = Total Sales - Returns - Sales Allowances - Discounts
(If this number is positive, you made a profit before taking into accounting your marketing and administration expenses.)
Gross Profit Margin = Gross Profit / Net Sales (or Total Revenue)
(In general, the higher this number is, the more efficient your business is.)
This ratio explains how much money you have left over to cover marketing and administrative expenses ... you know important stuff like wages, debt obligations, government taxes.
You may also want to calculate profit margin.
Profit Margin = Net Income / Net Sales (or Total Revenue)
(In general, the higher this number the better.)
This ratio calculates your safety margin if things start to "go south". It explains to readers of your financial statement how well you converted your sales into profits.
Remember earlier I said that you want to look at trends when doing ratio analysis.
In AIPB's accounting training publication Mastering Financial Statement
Analysis, they suggest if your profit margin is falling consistently
over numerous periods, look to see if your business also has falling
sales, increased cost of goods expenses (relates to gross profit margin)
or expenses (relates to profit margin) that have not been passed onto
customers or maybe even theft.
When you perform your monthly financial review, keep your eye out for unrecorded sales or overstated expenses. AIPB's publication suggests investigating changes between years that are greater than 10%.
Don't focus solely on your gross profit margin though. Two other ratios are also important, return on equity and return on assets, which we'll discuss another day.
Joshua Kennon wrote an article titled A Deeper Look at Gross Profit and Gross Profit Margin.
In this article, Joshua explains that if you can turn over your assets more frequently, you can "can generate more absolute profit relative to the capital invested in the enterprise than one with slower turnover but higher profit margins".
Joshua uses Walmart and Microsoft as examples. After examining the different business models each company uses, Joshua stresses that the key is decide which business model you are going to use and stick with it ... "as long as it works".
Ahhh, I forgot to tell you the business models Joshua looked at ... they were the low gross profit margin business model and the high gross profit margin business model.
That's it for this section on accounting training ... for now.
Let's wrap up this accounting training by turning our attention to your debt ratio and your debt service ratio.
Total liabilities in the debt ratio formula is often referred to as "total debt". This ratio explains how leveraged your business is.
Debt Ratio = Total Liabilities / Total Assets
Creditors like this ratio to be low ... the lower the better for them ... aim for .5 or less.Owners sometimes like this ratio to be high
... especially if they like risk. If the business fails, the owner walks away with only a small to moderate loss. You can see how this would make creditors nervous ... and they may begin requesting repayment of debt.
Bankers and long term creditors especially like to look at your debt service ratio
because it assures them your business can service its long term debt
from its operating profits. For them, your earning power is an important
factor in whether they will loan your business money. Any weakness here
may mean it is tough to impossible to get a bank loan or other source
This ratio is also referred to as interest coverage or times interest earned.
Debt Service = (Net Profit + Interest Expense +
Income Tax Expense) / Interest Expense
The higher this ratio the better. If it falls below 1.5, lenders may stop lending your business money. Why?
This ratio shows that your low coverage means you will likely face difficulties if you borrow more funds. Two or higher is good but your banker is most likely to compare your ratio with your industry average.
If you are looking for short term financing, your banker will be more interested in your working capital.
I found a really great Financial Difficulties checklist over at Keith Anderson CPA-CA's website albertacpa.com (formerly cabusinessadvisor.ca). It lists 39 early warning signs and 9 late warning signs. It is worth looking at to see how your business compares.
I'll wrap this up with this reminder ... just remember, ratios are most useful when looked at over a number of periods ... so you can identify trends ... and be proactive if necessary.
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