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Ratio Analysis Made Easy

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John W. Nelson III

CONSULTANCY

- Balance Sheet
- Profit & Loss

- Remember
- A balance sheet is only a picture in time
- A P&L is a moving picture in time
- This difference must be reconciled

- The period of time from the last fiscal date in days must be computed
- One year = 365 days
- 1st quarter = 90 days
- 3rd quarter = 270 days (and so forth)

- Everything is broken down to a day, a dollar or a percent
- Now they can be compared to like periods for the same business, i.e..
- This year to last year
- This quarter to last quarter

- Or compared to industry standards

- Industry Standards
- RMA
- To get the NAICS number, go to:
- http://www.census.gov/epcd/www/naics.html

- For more industry comparisons, go to:
- http://sbdcnet.utsa.edu/
- http://www.bizstats.com/

- Trade publications

- Balance Sheet
- Assets
- Current
- Fixed
- Other

- Liabilities
- Current
- Long Term

- Net Worth or Equity

- Assets

- ASSETS
- Current (turn to cash within 12 months)
- Cash
- Accounts Receivable
- Inventory
- Deposits & Pre-paid

- Current (turn to cash within 12 months)

- Liabilities
- Current Liabilities
- Long Term Liabilities
- Loans Due Affiliates or Owners

- Net Worth
- Common Stock or Equity
- Paid In Capital
- Retained Earnings
- Owners Draw (Partnership, LLC or Proprietorship)

- CAPITAL, NET WORTH OR EQUITY
- Assets minus the liabilities
- Net book value of the business
- How leveraged the business is
- Treasury Stock for corporations
- Value of the stock for a corporation
- Owners equity for partnerships, proprietorships or LLC’s

- Operating Statement, a/k/a Income & Expense Statement, Profit & Loss Statement or just P&L
- Revenue or sales
- Less Cost of Goods Sold (none if a service business)
- Beginning Inventory
- Plus purchases
- Less ending inventory
- Equals Cost of Goods Sold

- Equals Gross Profit

- Less All Expenses
- Operating Expenses
- Administrative Expenses
- Selling Expenses

- Equals Net Income
- Plus Other Income
- Less Other Expenses

- Equals Net Profit Before Taxes

- How you are doing, your report card
- If sales are up or down compared to last like period
- Your Cost of Goods Sold
- Your Gross Profit
- All expenses
- Profit or loss

- Ratios take the temperature of a business
- Ratios are computed by using the Balance Sheet & Operating Statement numbers
- They will tell you how liquid a company is
- They will tell you how it collects its money
- They will tell you how they pay their bills
- They will tell you how leveraged they are

- Current ratio = current assets/current liabilities
- Current Assets $170,000
- Current Liabilities$150,000
- Equals 1.13 or $1.13 in current assets to pay for each $1 in current liabilities. Bankers like 2 or higher.

- Working Capital considers what’s left after paying current debt
- Current Assets minus Current Liabilities
- Current Assets$170,000
- Current Liabilities$150,000
- Equals $ 20,000 left
- Bankers like a positive number.

- Acid test or Quick Ratio considers that inventory is not saleable, therefore eliminated
- Currents Assets – Inventory/Current Liabilities
- Current Assets $170,000
- Minus Inventory$ 85,000
- Equals$ 85,000
- Divided by Current Liabilities of $150,000
- Equals .56 or $.56 in Current. Assets to pay for each $1 in Current Liabilities.
- Bankers like 1 or higher.

- Accounts Receivable Turnover tells you how long it takes to collect them
- Accounts Receivable times 365 days/Annual Sales (days must match period for which the ratio is being computed)
- Accounts Receivable (from bal. sheet) $75,000 X 365 days = $27,375,000 (just a # to get to the answer)
- Divided by Ann. Sales$900,000
- Equals 30.4 days to collect, say 30 days
- Bankers like to see this at industry standards

- Assume your client needs $9,000 in working capital and can’t borrow it.
- Solution…
- Accts. Rec. of $75,000 divided by 30 days (A/R turnover) = $2,250 per day
- Collect the A/R in 26 days (4 days quicker) rather than 30 days
- 4 days X $2,250 = $9,000 now in cash

- Inventory Turnover Ratio tells how long it takes to sell the inventory
- Inventory times 365 days/Cost of Goods Sold (days must match period for which the ratio is being computed)
- Inventory (from bal. sheet)$85,000 X 365 days = $31,025,000 (just a # to get to the answer)
- Divided by Cost of Goods Sold of $540,000
- Equals 57.5 or 58 days to sell
- Bankers like to see this at industry standards

- Maximize working capital thru inventory control
- Inventory turns every 58 days & is $85,000
- 58 days into $85,000 = $1,466 per day
- Inventory can be restocked in 30 days, therefore you only need a 30 inventory on hand
- 58 days – 30 days = 28 days (less inventory needed) X $1,466 = $41,048 now in the checking account rather than in inventory

- Debt to Net Worth or Debt to Worth tells how leveraged a company is
- Total Debt divided by Total Liabilities
- Total Debt$204,000
- Total Liabilities $ 87,000
- Equals2.34 or for each $1 in net worth, creditors have $2.34, leverage 2.34 to 1. Bankers like 3 or lower.

- Accounts Payable Turnover tells how long a company takes to pay it’s bills
- Formula is Accts. Payable times 365 days divided by Cost of Goods Sold
- Accts. Payable$4,000 (from bal. sheet) X 365 days = $14,965,000 (a # just to get to the answer) divided by: Cost of Goods Sold$350,000
- Equals42.75 or within 43 days bills are pd
- Bankers like to see this 30 to 45 days or less

- Accts. Payable of $41,000 divided by 43 days (turnover) = $953 per day owed
- Usual terms due A/P are 2% 10 days, net 30 days, so lets see if we can pay in 10 days
- 43 days – 10 days = 33 days X $953 (A/P per day) = $31,449 needs to be pd. to get to 10 days
- Using the $41,048 saved in inventory, pay the payables down within 10 days & have $9,599 left for working capital, then take the 2% discount and save $7,000 (2% X $350K C of GS)

- Besides saving $7,000 taking the discounts consider this:
- 2%, 10 days
- Three 10 day period per month
- 3 X 2% = 6% savings per month
- 12 months X 6% = 72%
- This assumes that you invest what you would have paid & the interest was figured like this.

- Dug $9,000 out of Accts. Payable
- Dug $41,048 out of Inventory
- Saved $7,000 from taking discounts
- A total savings of $57,048
- Got a 72% ROI on amount saved

- Profit margin or the percent of profit from sales
- Net Profits divided by Net Sales
- Net Profit $ 53,000
- Net Sales $900,000
- Equals .0588 or 5.9% net profit

- Debt Service Coverage or how much $ do you have to pay current loan payments
- Formula is Net Profit plus Depreciation divided by Current Portion Long Term Debt (CPLTD)
- Net Profit $53,000 + $25,000 Depreciation= $78,000 cash flow for this year
- CPLTD is $6,000 (from bal. sheet) divided into $78,000 = 13.0
- Or you have $13 to pay every $l of term debt
- Bankers like to see 2 or higher

- Thanks
- For your time
- For you attention
- If you need further information:
- John W. Nelson III
- 16 Park St.
- Newport, RI 02840-2104
- Phone/fax 401-847-3083
- E-mail: [email protected]
- www.johnwnelson3rd.com
- For copies of my publications: [email protected]