In order to gauge how your business is doing, you'll need more than single numbers extracted from the financial statements. And you'll need to view each number in the context of the whole picture.
For example, your income statement may show a net profit of $100,000. But is this good? If this profit is earned on sales of $500,000, it may be very good. But if sales of $2,000,000 are required to produce the net profit of $100,000, the picture changes drastically. A $2,000,000 sales figure may seem impressive, but not if it takes $1,900,000 in assets to produce those sales.
The true meaning of figures from the financial statements emerges only when they are compared to other figures. Such comparisons are the essence of why business and financial ratios have been developed.
Working with the Most Important Ratios
Various ratios can be established from key figures on the financial statements. These ratios are very simple to calculate—sometimes they are simply expressed in the format "x:y," and other times they are simply one number divided by another, with the answer expressed as a percentage. Your accounting software may be able to produce them in a few clicks, or you can always export the data to a spreadsheet to let technology do most of the work.
These simple ratios can be a powerful tool because they allow you to immediately grasp the relationship expressed. When you routinely calculate and record a group of ratios at the end of every accounting period, you can assess the performance of your business over time, and compare your business to others in the same industry or to others of a similar size. By doing so, you won't be alone — banks routinely use business ratios to evaluate a business that's applying for a loan, and some creditors use them to determine whether to extend credit to you.
When you compare changes in your business's ratios from period to period, you can pinpoint improvements in performance or developing problem areas. By comparing your ratios to those in other businesses, you can see possibilities for improvement in key areas. A number of sources, including many trade or business associations and organizations as well as commercial services, provide data for comparison purposes. Your accountant may be a good source of information on how your business compares to similar ones in your particular locale.
There are dozens and dozens of financial ratios that you can look at, but many will have little or no meaning for your business. In the following sections we'll concentrate on those that are most commonly considered to have the most value for making small business decisions. The ratios fall into four categories:
- Liquidity Ratios
- Efficiency Tatios
- Profitability Ratios
- Solvency Ratios
The liquidity ratio is generally the best place to start.
Understanding Liquidity Ratios
These ratios are probably the most commonly used of all the business ratios. Your creditors may often be particularly interested in these because they show the ability of your business to quickly generate the cash needed to pay your bills. This information should also be highly interesting to you, since the inability to meet your short-term debts would be a problem that deserves your immediate attention.
Liquidity ratios are sometimes called working capital ratios because that, in essence, is what they measure.
The liquidity ratios comprise:
- The Current Ratio
- The Quick Ratio
Liquidity ratios are commonly examined by banks when they are evaluating a loan application. Once you get the loan, your lender may also require that you continue to maintain a certain minimum ratio, as part of the loan agreement. For that reason, steps to improve your liquidity ratios are sometimes necessary. That's why you'll need to familiarize yourself with both components of the liquidity ration.
Figuring Your Current Ratio
This ratio provides a way of looking at your working capital and measuring your short-term solvency. The current ratio is in the format x:y, where x is the amount of all current assets and y is the amount of all current liabilities.
Generally, your current ratio shows the ability of your business to generate cash to meet its short-term obligations. A decline in this ratio can be attributable to an increase in short-term debt, a decrease in current assets, or a combination of both. Regardless of the reasons, a decline in this ratio means a reduced ability to generate cash.
If you're looking to secure money via the sale of some stock through an initial public offering, many State Securities Bureaus will require that you have a current ratio of 2:1 or better.
Merely paying off some current liabilities can improve your current ratio.
If your business's current assets total $60,000 (including $30,000 cash) and your current liabilities total $30,000, the current ratio is 2:1.
Using half your cash to pay off half the current debt just prior to the balance sheet date improves this ratio to 3:1 ($45,000 current assets to $15,000 current liabilities).
If your business lacks the cash to reduce current debts, long-term borrowing to repay the short-term debt can also improve this ratio.
If your current assets total $50,000 and your current liabilities total $40,000, the poor 5:4 current ratio changes to a better 2:1 ratio if $15,000 of long-term debt is used to refinance an equal amount of short-term debt (you'll now have $50,000 in current assets to $25,000 in current liabilities).
Other possibilities may reveal themselves if you carefully scrutinize the elements in the current asset and current liability sections of your company's balance sheet. The idea is simply to take steps to increase total current assets and/or decrease total current liabilities as of the balance sheet date. For example:
- Can you place a higher value on your year-end inventory?
- Can pending orders be invoiced and placed on your books sooner to increase your accounts receivable?
- Can purchases be delayed to reduce accounts payable?
Figuring Your Quick Ratio
The quick ratio, also known as the "acid test," serves a function that is quite similar to that of the current ratio. The difference between the two is that the quick ratio subtracts inventory from current assets and compares the resulting figure (also called the quick current assets) to current liabilities.
Why? Inventory can be turned to cash only through sales, so the quick ratio gives you a better picture of your ability to meet your short-term obligations, regardless of your sales levels. Over time, a stable current ratio with a declining quick ratio may indicate that you've built up too much inventory.
If your quick current assets are $90,000 and your current liabilities are $30,000, your acid test ratio would be 3:1 (90,000:30,000).
How to Improve Your Quick Ratio
Because this ratio is quite similar to the current ratio, but excludes inventory from current assets, it can be improved through many of the same actions that would improve the current ratio. Converting inventory to cash or accounts receivable also improves this ratio.
In evaluating the current ratio and the quick ratio, you should keep in mind that they give only a general picture of your business's ability to meet short-term obligations. They are not an indication of whether each specific obligation can be paid when due. To determine payment probability, you may want to construct a cash flow budget.
In general, a quick or acid-test ratio of at least 1:1 is good. That signals that your quick current assets can cover your current liabilities.
Example of a Typical Income Statement
This typical income statement showing three years' information should demonstrate the value in an income statement.
|Smith Manufacturing Company|
Years Ended December 31, 201Z, 201Y, and 201X
|Sales||$ X||$ X||$ X|
|(Sales returns and allowances)||($ X)||($ X)||($ X)|
|Net sales||$ X||$ X||$ X|
|Cost of goods sold|
|Beginning inventory||$ X||$ X||$ X|
|Cost of goods purchased||$ X||$ X||$ X|
|(Ending inventory)||($ X)||($ X)||($ X)|
|Cost of goods sold||$ X||$ X||$ X|
|Gross profit||$ X||$ X||$ X|
|Selling expense||($ X)||($ X)||($ X)|
|General and administrative expense||($ X)||($ X)||($ X)|
|Total operating expenses||$ X||$ X||$ X|
|Income from operations||$ X||$ X||$ X|
|Interest expense||$ X||$ X||$ X|
|Pretax income||$ X||$ X||$ X|
|Income taxes||($ X)||($ X)||($ X)|
|Net income||($ X)||($ X)||($ X)|
|(The notes are an integral part of this statement.)|
Using the Income Statement
As with the balance sheet, an in-depth knowledge of accounting is not necessary for you to make good use of the income statement data.
For example, you can use your income statement to determine sales trends. Are sales going up or down, or are they holding steady? If they're going up, are they going up at the rate you want or expect? Also, if you sell goods, you can use the income statement to monitor quality control. Look at your sales returns and allowances. If that number is rising, it may indicate that you have a problem with product quality.
Gross profit margin should be closely monitored to make sure that your business is operating at the same profitability levels as it grows. To find this margin, divide your gross profit (sales minus cost of goods sold) by your sales for each of the years covered by the income statement. If the percentage is going down, it may indicate that you need to try to raise prices.
Also, check out your selling expense. It should increase only in proportion to increases in sales. Disproportionate increases in selling expense should be followed up and corrected.
General and administrative expenses should also be closely watched. Increases in this area may mean that the company is getting too bureaucratic and is in line for some cost-cutting measures, or that equipment maintenance is too expensive and new equipment should be considered.
Interest expense is an important measure of how your company is doing. If your interest expense is increasing rapidly as a percentage of sales or net income, you may be in the process of becoming overburdened with debt.
Creating a Statement of Changes in Position
The statement of changes in financial position provides data not explicitly present in the balance sheet or the income statement. This statement helps to explain how your company acquired its money and how it was spent. This statement can also help to identify financing needs, to identify cash drains, and to identify holes in the cash budgeting process. Use the statement of changes in financial position as a tool to analyze cash inflows and outflows. Also, use it as a starting point to forecast future cash flows and financing requirements.
Accounting standards give preparers of this statement quite a bit of flexibility in how they arrange and format the information. However, the Financial Accounting Standards Board has stated its intention that this statement should evolve into one whose focus is on cash and changes in cash. This position has been strongly endorsed by the Financial Executives Institute (FEI). As might be expected, more and more companies are using a cash focus for the statement of changes in financial position. In fact, the statement is often called the "Sources and Uses of Cash Statement."