|
FAVORITE SITE for Small Business and personal management tips. Check out our
PARTNERS
100 PLUS |
|---|
|
|---|
When a successful business strategist is referred to as someone who "knows how to read financial statements" the person is likely skilled at calculating and understanding the relationships within financial statements.
This unit goes beyond the normal scope required of the usual small business plan. You may require this additional support.
You can sell your plan much better, in the presence of a lender or investor, when you are familiar with with these terms, formulae and calculations.
Avoid presenting details on something you don't fully understand. It undermines your credibility in other areas.
Most common ratios are described. You select which are relevant and appropriate for your situation whether it is a proposed startup or an expanding business or a business in transition during growth, merger. or purchase.
References to the reader (of the business plan) includes a potential lender, investor or other such analyst. Hopefully, the reader will include you, the manager, as you proceed with your enterprise. Enterprise is used as a generic term to cover proprietorship, partnership or corporation
If you are reading this unit, it is quite probable you're not thoroughly familiar with financial ratios. It's even probable you are unfamiliar with ratios in general. For this reason, we repeat descriptors using different words and terms so you can relate to other materials you have read at different times.
A ratio is a relationship. A financial ratio ascribes numbers to the relationship between two items on financial statements.
A dictionary defines a ratio as, "the quantitative relation between two amounts showing the number of times one value contains or is contained within the other." Those numbers are expressed as a:b such as 2:1 or 1:2. For example, in a basket of fruit where there are 10 oranges and 5 apples, the ratio of oranges to apples is 2:1 and the ratio of apples to oranges is 1:2 obtained from the fraction 10/5. This explanation is not to insult your intelligence, rather, to demystify the subject of financial ratios for managers not heavily into number-crunching.
A percent is a ratio that states any proportion or share in relation to a whole or an amount in each hundred. Some times a ratio states how many times one item exceeds another.
These numbers become data items which can be compared with all other similar calculations. In other words, a method for comparing apples and oranges. With some searching diligence, the ratios can be compared with those issued by financial institutions, financial analysts and in various industry publications.
While financial ratios relate to the durability or survivability of an enterprise, another set of ratios called operational ratios relate to the relative efficiency of an operation or the effectiveness of the manager.
Most readers expect and use them. These are important for bankers, sophisticated investors, the comfort for angel investors and for the confidence of the manager.
Your ratios can be compared with those of successful or unsuccessful companies with similar circumstances.
They prevent or expose inconsistencies between various parts of your business plan which severely undermines your credibility during a presentation.
For a startup manager to apply ratios to pro-forma (speculated) data is an indication of the manager's mindset and his/her propensity for carefully managing by "the numbers."
For the reader they:
A range describes upper and lower limits for a value. Some financial reports publish ratios in a range which includes an average or median with lower and upper limits. Various readers will set the lower and upper limits they are prepared to accept. Lenders specializing in specific industries will develop their acceptable limits based on their own historical data.
In many of these financial reports there is very little change over the years. This adds to their credibility. Exception are often caused by innovative entrepreneurs.
Acceptable ranges vary from one type of business to another because the general ranges listed in most textbooks are too vague. For instance: most textbooks state the acceptable range for the current ratio is from 1 to 2. This is very wide as the current ratio depends on your circumstances, reserves, situation, risk aversion of vested interests and perceived short and long demand for the product or service.
You will take into consideration the following factors and SELL your interpretation to your reader.
Most of these are expensive because of the investment in massive data gathering and the purchasers are usually large corporations with suitable budgets. It may be possible to purchase data for a narrow niche.
The most popular are from Dunn & Bradstreet and Robert Morris Associates. At best, they are approximations or provide a trend analysis because of restricted collection methods, use of dated material, size groups not compatible with small startups and sweat capital is excluded. For convenience, they are classified by Standard Industrial [SIC] codes. If your enterprise is not listed, you can interpolate between those with similar circumstances.
Alternative sources:
Yes this is a lot of work. Remember, the second most important benefit of a business plan is its use as a management plan.
The remainder of this unit describes ratios by stating what they measure, how they are used and how they are calculated.
Which ratios to use depends on your readers preferences and the nature of your business.
The values used in these calculations are from the financial statements of the ABC Company listed at the end of this document.
The three main groups are liquidity, leverage and profitability.
Liquidity ratios are used to measure your enterprise's ability to pay its bills on time.
They can be overall measures of liquidity or measures of specific assets.
Liquidity is the availability of liquid assets to an enterprise.
Liquid assets are those assets held in or easily converted into cash.
Measures the number of times that your enterprise's current assets cover your current liabilities.
Indicates your capacity to pay your short-term obligations.
Expresses the working capital relationship of current assets available to meet the company's current obligations.
You expect to pay your current bills with the cash flowing in from your operations. What happens when that flow decreases or is interrupted? You would have to step up the collections of your accounts receivable and even have an inventory sale. The current ratio shows how many of those assets you have available to pay such current liabilities as your payroll, notes and accounts payable.
A lender or an investor needs to know how your enterprise can cope with the normal ups and downs experienced by most businesses.
| Formula | |||
|---|---|---|---|
| current assets | = | $453,383 | = 1.44 times |
| current liabilities | $314,324 | ||
| [Using data from the financial statements of ABC company displayed below.] | |||
ABC Company has $1.44 of current assets to pay for $1.00 of current liabilities or a ratio of 1.44:1
A current ratio of 2.00:1 is considered the norm. Of course, this covers the entire range of all industries.
The quick ratio, sometimes called the acid test ratio, is similar to the current ratio. This ratio is a further refinement of the current ratio where the inventories are removed from the current assets. It is considered a more reliable indicator of an enterprise's ability to meet its short-term financial obligations because inventory can sometime be difficult to liquidate. Potential creditors like to use this ratio because if reveals a company's ability to pay off obligations under the worst possible conditions. This is especially important for the startup enterprise when the risks of failure are so much greater and less known.
This would become more important for the reader when the enterprise's ability to quickly convert your type of inventory into cash becomes more difficult.
| Formula | |||||
|---|---|---|---|---|---|
| current assets - inventories | = | 453383 - 139,725 | = | 313,658 | = 1.00 times |
| current liabilities | 314,324 | 314,324 | |||
| [Using data from the financial statements of ABC company displayed below.] | |||||
The current and quick ratios give an overall measure of your enterprise's liquidity. The reader of your business plan will want to look at the strength of the specific assets, namely, the accounts receivable.
We mentioned above that an enterprise may have to rely on collecting cash from accounts receivable a little faster. The reader will be concerned about the probable ease or speed this conversion. This can be measured with the turnover rate or the collection period.
| Formula | |
|---|---|
| Receivables turnover ratio | = annual credit sales / average accounts receivable |
| = 2,270,323 / ((143,893 + 162,878) / 2) | |
| = 2,270,323 / 153,386 | |
| = 14.80 times | |
| [Using data from the financial statements of ABC company displayed below.] | |
ABC Company turns over its receivables 14.8 times a year.
Average receivables is obtained by adding the balance of outstanding receivables at the beginning of the year (end of previous year) to those at the end of the year and dividing that sum by 2. This assumes these year-end balances are at typical levels and that all sales were credits to accounts receivables.
| Formula | |
|---|---|
| Average collection period | = average accounts receivable / (annual credit sales / 365) |
| = ((143,893 + 162,878) / 2) / 2,270,323 / 365 | |
| = 153,385 / 6,220 | |
| = 24.66 days | |
| [Using data from the financial statements of ABC company displayed below.] | |
Only one of these two above measures is required since one can be derived from the other.
A table showing the Aging of Accounts Receivable provides a better picture when evaluating with ratios. The credibility of a pro-forma table for a proposed startup would depend on the related circumstances and the attitude of the reader.
| Aging of Accounts Receivable for Sample Co. as of Feb. 30, 2005 | |
|---|---|
| Number of Days | Outstanding |
| Outstanding | Accounts Receivable |
| 0 - 15 | $ 93,000 |
| 16 - 30 | $ 36,000 |
| 31 - 45 | $ 18,500 |
| More than 45 | $ 1,835 |
The liquidity of a firm's inventories is reflected in the number of time the firm's average inventory is turned over during the year. The inventory ratio requires confirmation by other measures and a more thorough examination of contents because rapid turnover on a few items or a slow turnover on others could skew the results.
| Formula | |
|---|---|
| Inventory turnover ratio | = cost of goods sold / average inventory |
| = 1,520,891 / ((139,725 + 141,410) / 2) | |
| = 1,520,891 / 140,568 | |
| = 10.82 times | |
| [Using data from the financial statements of ABC company displayed below.] | |
ABC turns its inventory almost eleven times a year or almost every month. It's a good strategy to mention in your plan the false assumptions associated with this conclusion.
Average inventory is the average of the beginning and ending inventories. Sales are sometimes used in the numerator of the inventory ratio rather than the cost of goods sold. This would include markup, a variable which fluctuates across different situations.
This ratio is obtained by dividing the 'Total Liability or Debt' of a company by its 'Owners Equity' also know as 'Net Worth'. The ratio measures how the company is leveraging its debt against the capital employed by its owners. If the liabilities exceed the net worth then, in that case, the creditors have more stake than the share owners.
| Formula | |
|---|---|
| Debt to Equity Ratio | = Total Liabilities / Owners Equity or Net Worth |
| = 619,888 / 548,286 = 1.13 | |
| [Using data from the financial statements of ABC company displayed below.] | |
The Interpretation: ABC Company has $1.13 cents of Debt and only $1.00 in Equity to meet the total obligations.
A review of your industry's norms and ratios for this ratio allows you to compare whether it is above, below or equal to others in your industry.
This reveals the extent to which a company is financed with debt. Creditors look at this ratio when they are trying to decide what the chances are you won't be able to make good on your business loans and obligations. A healthy company has a good balance between assets provided through debt and assets provided by the enterprise's owners. The lower it is, the greater the chance of your company will be able to ride out the rough times.
Book values are easier and quicker to find. In a longer established enterprise, the replacement values are usually used in computing the debt ratio. Using book values (purchase cost) could yield significantly different results than using market values (replacement cost.)
| Formula | |
|---|---|
| Debt to Assets Ratio | = total liabilities (current and long-term) / total assets |
| = 619,888 / 1,168,174 = 0.5306 or 53 % | |
| [Using data from the financial statements of ABC company displayed below.] | |
ABC Co has financed a little more than half of its assets with borrowed funds.
To distinguish whether short or long-term debt was used to acquire assets calculate the long-term debt ratio.
| Formula | |
|---|---|
| Long-term Debt Ratio | = long-term debt / total assets |
| = 305,564 / 1,168,174 = 0.2616 or 26 % | |
| [Using data from the financial statements of ABC company displayed below.] | |
This is extended to find the percent of assets financed with current debt.
debt ratio - long-term debt ratio = 53 % - 26 % = 27 %
Measures how your operations can pay the financing charges associated with your borrowed financing. While this is a common and natural concern of financial analyzers, this ratio requires extra scrutiny because: (a) operating income may not reflect all the earnings available to meet interest and other financial charges and, (b) it assumes interest expense is the only finance charge that needs to be covered.
It does have more meaning for a small business operation and the input data is easy to find in the financial statements. It is good accounting practice to list interest as a separate expense. Despite the weaknesses, it does serve as a meaningful indicator.
| Formula | |
|---|---|
| Times-interest-earned ratio | = net operating income / annual interest expense |
| = 100,682 / 31,071 | |
| = 3.24 times | |
| [Using data from the financial statements of ABC company displayed below.] | |
CAUTION - Ensure this is adjusted and updated to reflect the various versions of your financing proposals.
Profitability ratios serve as overall measures of the effectiveness of the management and can be segmented into two groups: profitability in relations to sales and profitability in relation to investment
The profit margin is also known as the Return On Sales and net worth is often called Return on Equity.
Reflects management's ability to control expenses and to turn sales into profits.
Your gross profit ratio tells you how much of each sales dollar you can expect to use to cover your operating expenses and profit. In other words, it measures the difference between what it costs to produce a product and what you're selling it for. While some ratios uncover trends by looking at the past, the gross profit margin is a tool you can use to chart your company's future.
| Formula | |
|---|---|
| Gross profit margin | = gross profit / net sales |
| = 749,432 / 2,270,323 = 0.33 or 33 % | |
| [Using data from the financial statements of ABC company displayed below.] | |
ABC's gross margin constitutes 33% of its sales. The gross margin is affected by the cost of goods sold and management's markup on its cost of goods sold. An analyst will expect some information on how the costs are calculated and of any external influences (competition, regulations, etc.) on the markup rate.
The operating profit percentage ratio compares sales to operating profit. Operating profit is what's left from your sales dollar after you've deducted your cost of goods sold and your ordinary operating costs.
The operating profit percentage tells you the percentage of your sales that turn into profit. Because the figure excludes miscellaneous income and tax expenses, the operating profit percentage produces an accurate picture of the profitability of your primary business. Reductions in this figure over time might indicate a need to re-evaluate your pricing or your suppliers, or look for ways to cut down on your operating expenses.
| Formula | |
|---|---|
| Operating profit margin | = operating income / net sales |
| = 100,682 / 2,270,323 = 0.044 or 4.4 % | |
| [Using data from the financial statements of ABC company displayed below.] | |
The operating income margin of 4.4% reflects both ABC's operating expenses and its cost of goods sold. It serves as an overall measure of operating effectiveness since the only expenses not accounted for in operating income are finance charges and taxes.
| Formula | |
|---|---|
| Net profit margin | = net income after taxes / net sales |
| = 37,548 / 2,270,323 = 0.0165 or 1.7 % | |
| [Using data from the financial statements of ABC company displayed below.] | |
After all expenses are paid, including interest and taxes, ABC earns 1.7% of each sales dollar in profits. A startup enterprise may have to consult an accountant to get an estimate of taxes. A review of stated profits for many companies may surprise you to find such small margins. Note this is the amount upon which taxation is assessed. This small profit on each sales dollar can result in a very sizable return on invested capital, the purpose for the next two ratios.
Where the objective is to measure the enterprise's profitability in relation to invested funds used to generate those profits and is the most revealing of the overall effectiveness of management.
| Formula | |
|---|---|
| Operating income rate of return | = operating income / total tangible assets |
| = 100,682 / 1,168,174 = 0.086 or 8.6 % | |
| [Using data from the financial statements of ABC company displayed below.] | |
Tangible assets excludes such intangibles as goodwill which a startup does not yet possess. In addition, goodwill can be highly subjective and, therefore, the true value is highly suspected. ABC's management produced an 8.6% return on invested capital before interest and taxes.
Return on Total Assets Ratio is often referred to as return on investment or ROI.
This measures how well a company's management team is doing its job because it reveals how much income the management has been able to squeeze from each dollar's worth of a company's assets. Investors and use this ratio to evaluate a company's leadership.
Use an average of a enterprise's assets at the beginning and end of the fiscal year when there are seasonal swings.
| Formula | |
|---|---|
| Return on total assets ratio | = net income / total tangible assets |
| = 37,548 / 1,168,174 = 0.032 or 3.2 % | |
| [Using data from the financial statements of ABC company displayed below.] | |
ABC management has produced, after interest and taxes, a net return of 3.2% on its total investment in tangible assets. Such a slim margin is why many small business entrepreneurs often think of alternative investments. After all the perquisites are considered, very few do.
Someday...
Another scenario will be added to this unit depicting the ratios in pro-forma statements of a startup.
That 'someday' will come sooner if you request it to gerry@UncleMaxSays.com
Used for supplying data for the calculations in the various financial ratio formulae above.
| ABC Company | |||
|---|---|---|---|
| An on-going enterprise Balance Sheet | |||
| ASSETS | |||
| Current | Percent of Total Assets | ||
| Cash | $ 134,952 | 11.55 | |
| Accounts receivable | 143,893 | 12.32 | |
| Inventories | 139,725 | 11.96 | |
| Prepaid expenses | 34,813 | 2.98 | |
| Total Current Assets | 453,383 | 38.81 | |
| Property, Plant and Equipment (Long-term Assets) | |||
| Land | 71,261 | 6.10 | |
| Building | 678,182 | 58.05 | |
| Machinery, equipment and furniture | 661,730 | 56.65 | |
| Transportation equipment | 52,829 | 4.52 | |
| Total property, plant and equipment | 1,464,002 | 125.32 | |
| Less: Accumulated depreciation | (749,211) | (64.14) | |
| Net property, plant and equipment | 714,791 | 61.19 | |
| Total assets | $ 1,168,174 | 100.00 | |
| LIABILITIES AND STOCKHOLDERS' EQUITY | |||
| Current Liabilities | |||
| Notes payable (current, short-term) | $ 21,847 | 1.87 | |
| Accounts Payable | 235,943 | 20.20 | |
| Other liabilities and accrued expenses | |||
| Accrued wages | 15,121 | 1.29 | |
| Accrued taxes | 7,774 | 0.67 | |
| Accrued interest | 16,488 | 1.41 | |
| Accrued expenses (other) | 17,151 | 1.47 | |
| Total current liabilities | 314,324 | 26.91 | |
| Long-term debt | 305,564 | 26.16 | |
| Stockholders' Equity | |||
| Capital Stock | 220,000 | 18.83 | |
| Retained earnings | 328,286 | 28.10 | |
| Total liabilities and stockholders' equity | $1,168,174 | 100.00 | |
Note the calculation of the percentages in the far right column. This is a convenience for the casual reader.
| ABC Company | ||
|---|---|---|
| An on-going enterprise Income Statement | ||
| Percent of Sales | ||
| Sales (net) | $ 2,270,323 | 100.00 |
| Cost of goods sold | 1,520,891 | 66.99 |
| Gross profit | 749,432 | 33.01 |
| Operating expenses | ||
| Selling | 414,060 | 18.24 |
| Delivery | 113,516 | 5.00 |
| General and administrative | 121,174 | 5.34 |
| Total operating expenses | 648,750 | 28.58 |
| Operating income | 100,682 | 4.43 |
| Interest expense | 31,071 | 1.37 |
| Income before taxes | 69,611 | 3.07 |
| Income taxes | 32,063 | 1.41 |
| Net Income | 37,548 | 1.65 |
Note the calculation of the percentages in the far right column. This is a convenience for the casual reader.
Whatever your situation or budget - let's discuss it!
For a FREE consultation with NO obligations, send a brief request to: BPCoach@UncleMaxSays.com
Or Learn More
|
FAVORITE SITE for Small Business and personal management tips. Check out our
PARTNERS
100 PLUS |
|---|
|
|
|---|
© 2004-2006 UncleMaxSays.com
UncleMaxSays.com is a division of Kamloops International College Inc.
Privacy Policy Terms of ServiceSmall Business - Time Management - Business Plans - Business Plan Coaching
