Ratio Analysis Tools to measure your business Part

Ratio Analysis Tools to measure your business Part TWO BUS 203 Bus Fin Mgt _ RATIOS Spring 2006 copyright SJH

What is Ratio Analysis • A tool to measure the progress of your business and to compare with the competition. • Ratios measure proportions or relationships. • Ratios allow you to make comparisons with your own history and the competition.

Using Ratios without Fear • Think of a ratio as a friend • Ratios are simple to calculate (especially with a calculator). • Ratios DO NOT take the place of good management. • They are tools to point out areas that need more exploring.

Basic Fraction Review • When comparing a part to a whole the whole is always the base. net profit sales • A percentage can increase by more than 100% (but it cannot decrease by more than 100%).

Rules for Ratios • Maintain an Objective Attitude (don’t use them to predetermine, use them to have a better understanding). • Compare apples with apples and oranges with oranges: same size and type of business. Hint: Use industry standards. • Don’t use meaningless numbers. • Avoid using the wrong figures.

Types of Ratios • Liquidity - liquidity ratios help you determine your ability to pay debt. • Profitability - measures your ability to make a profit. • Efficiency or Activity - shows how well you are conducting business. • Leverage or Debt - refers to the degree to which a firm relies on borrowed funds in its operations.

Liquidity Ratios: Measures Your Ability to Pay Short-Term Debt • Current Ratio – current assets / current liabilities…the Current Ratio should be 2 x liabilities or 200% • Quick Ratio or “Acid Test” Same as Current Ratio, but it doesn’t’ include inventories (so only cash and a/r are counted) • Turnover of Cash or “Working Capital” sales / working capital Shows your ability to handle cash flow in the business (working capital is CA-CL)

Current, Quick Ratios & Working Capital : What the Banker looks at first. • A “low” ratio could indicate that the company cannot pay its bills. • A “high ratio” could indicate that there is a lot of money tied up in cash or securities. • The banker will compare the business to other like businesses. • A “safe” Quick Ratio is at least 1. 0 times the current liabilities. This shows that inventory is being managed! • For Working Capital - sales should be 5 or 6 times the working capital (depending on the business). • Some of this information you can find on the Balance Sheet and some on the Income Statement.

Profitability or Performance Ratio Tools • Profitability is WHY we are in business! • We want a better Return on Our Money or ROI (return on investment). • Profitability measures how effective we are at using our various resources to achieve profit. • Large businesses use profitability measures to show management performance. • As a general rule, profitability comes from changes in price or volume.

Profitability Ratios Commonly Used • Net Profit Ratio = Earnings Before Taxes / Net Sales • Rate of Return on Sales – how much net profit was derived from every dollar of sales. • ROI - Return on Investment = EBT / Net Worth • Return on Assets = Net Profit / Total Assets

Efficiency or Activity Ratio Tools • Show us how efficient you are at collecting your money and how good you are at turning over inventory. • Efficiency Ratios help keep your business in balance. • They often highlight management skills and are keenly viewed by bankers. • Efficiency ratios determine if you can handle growth.

Common Efficiency Ratios: Average Collection Period • Average Collection Period determines the number of average days it takes you to collect your money AR x 365/ Sales • The accepted standards depend on your industry norm, and your credit policy. • A high ratio could indicate a number of bad accounts, or poor collection practices.

Efficiency Ratios: Inventory Turnover • A tool to measure how fast you are moving your inventory. COGS / Average Inventory • Depending on your industry, you want to turn your “stock” 6 times per year. • A slow inventory turnover could mean you have the “wrong” stock or you are carrying too much. • Fast inventory turn-over increases cash flow.

Debt Ratios The Debt to Owner’s Equity Ratio Measures the degree to which the company is financed by funds that must be repaid. Bankers have benchmarks that they will look at before considering offering a loan. A ratio of above 1 or 100% would show that a firm has more debt than equity. Lower ratios show greater long-term financial safety. Total Liabilities / Owner’s Equity

Using a Comparison Chart can help a manager to. . • Compare your historical progress • Compare your self to the industry (Check out RMA or your trade association for industry standards) • Plan for seasonality • Plan for future expansion • Control Management - inventory and cash flow • Make sure you are on the right path!