| It's
one thing to learn the meaning of financial statements. Generally, once you learn
how they are developed, it is rather easy to read them. But there is a third step
in the evaluation process -- using ratio analysis with those financial statements
to interpret the financial condition and performance of your company. Ratio
analysis is a prerequisite procedure when bankers and other lenders evaluate your
loan application. These simple formulas evaluate your firm's performance or the
projected financial statements you submit in anticipation of how your company
will succeed with the use of loan proceeds. And when the numbers are 'crunched'
the lender compares your company's results with those of existing businesses in
the same type of product or service industry as yours. Probably
the most compared set of ratios are those compiled by Robert Morris Associates
in their Annual Statement Studies database. There are hundreds of ratio formulas
that can be applied to a comprehensive set of financial statements, but for the
scope of this column we will limit ourselves to 4 different formulas in 3 different
categories. They are very common and most useful to small business:
1.Liquidity ratios including the current and quick
formulas.
2.Coverage ratio of earnings before interest and taxes.
3.Operating
ratio of net sales-to-net fixed assets. These
should be sufficient to become familiar with the analysis process. Liquidity ratios
are designed to measure your company's ability to meet current liabilities with
current assets. In other words, are you able to generate sufficient funds, by
liquidating current assets, to pay off the current debt? The
first, most common tool is the current ratio. This equals:
Total Current Assets / Total Current Liabilities
Example: $50,000 / $20,000 = 2.5
In the example above you have total current assets of $50,000 and current liabilities
of $20,000. Generally, a ratio of 2.5 is an excellent, rarely attained ratio,
and means you have $2.50 in current asset value to cover every $1 of current liability.
Suppose you sell product and maintain
inventory. The quick ratio then applies, and it equals: (Total Current Asset -
Inventory) / Total Current Liability ($50,000 - $20,000) / $20,000 = 1.5 Excluding
an inventory of $20,000, you now have only $1.50 of current assets to cover every
$1 of current liabilities. 1.5 remains a good quick ratio in many industries.
But remember your inventory is listed
at your cost, not the anticipated retail value. The concept behind this ratio
assumes it is harder to readily liquidate inventory if the need arises. Earnings
before interest (on notes payable) and taxes is a coverage ratio intended to show
how well your company can service its debt. The
formula is: Earnings before
Interest & Taxes / Annual Interest Expense
Example:
$100,000 / $10,000 = 10.0 You
have $10 of earnings before interest expense and taxes to pay for every dollar
of interest expense. A higher ratio demonstrates a greater ability to pay interest
expense. Remember you pay interest expense before income tax. And this ratio is
of great concern to lenders. They are the recipients of your interest expense.
Finally, operating ratios are intended
to show how well the company manages its assets to generate sales. In this case
we use the example of net sales-to-net fixed assets (original fixed asset value
minus accumulated depreciation): Net
Sales / Net Fixed Assets
Example: $120,000
/ $50,000 = 2.4 In other
words, you are generating $2.40 in net sales (total sales minus cost of sales)
for every $1 of net fixed assets. In many industry sectors this is an excellent
ratio. These are simple yet excellent tools to analyze financial performance.
And they become even more valuable when comparing your financial statements from
one year to the next. But you also want
to compare your results to industry standards. Those standards are a reflection
of your industry's financial performance. It is good business practice to know
how well you perform from one year to the next, but equally important to know
where you stand in comparison to the competition. For more detailed information
about ratio analysis I suggest you visit the web site of Robert
Morris Associates or Dunn & Bradstreet.
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