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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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