It’s All In The Numbers
Ok, now that the partying is out of the way, take off those hats, and recycle those champagne bottles, it’s time to get back to business. Because, if you're like most businesses, your fiscal year just ended. If so, you have now entered the dreaded Year-End-Close Season.
What? The accountants are asking you to count every piece of inventory you have. Don’t they know it’s impossible to count 100,000 widgets? And all those schedules they're asking for. How in the world are you going to get all the information the accountants want and run you business too? It’s impossible! And to top it all off, you’re only doing this to keep the bankers happy because their auditors (aka accountants) get upset when there are no financial statements to back your loan. Don’t they realize all that matters is that your collateral will pay the loan ten times over? And you ask yourself how you're going to run a business and get all this information for all these people, and, and …
Hold on. Wait a minute. Take a deep breath, stop sucking your thumb and remember –– we're all on the same side. When you make money, so do your bankers and accountants. And while some may chuckle at our list of complaints above, others can fully identify with them. Even we accountants relate to the time pressures our clients are under. So, we do our best to help you, in preparing information for our review, such that you do all this is necessary, and nothing more.
That’s what we’re all about this month. We want to bring greater meaning to all those numbers you look at on those fancy financial statements we prepare for you at the end of the year, because those financial statements, if used properly, can be an invaluable tool for running your business. So, let’s take a look at your financial statements the way your banker or an investor might look at them.
Let’s start with the basics. There are four fundamental financial statements. Almost everyone has heard about the balance sheet and income statement (or P&L), but there two others that can tell you a great deal about the business. These statements are commonly referred to as the statement of stockholder’s (or owner’s) equity and the statement of cash flow, respectively, and go into greater detail about business.
Another element of a complete set of financial statements is the Summary of Accounting Policies. This is a narrative which tells whoever is reading the financial statements, just how you accounted for your activities in the report period. This information is extremely important when a reader begins to look at the composition of assets and liabilities and how you've determined income.
For example, if you use the cash basis of accounting, the bottom line net income on your income statement, adjusted for non-cash expenses like depreciation, will basically reflect how much cash you generated during the year. If you use the accrual basis for you accounting, you may not have received cash for a significant portion of your sales and still owe a lot to your creditors for the expenses you recorded on the income statement. Financial statements prepared on the accrual basis require a great deal of adjustment to determine just how much cash operations actually generated.
The final part of the basic financial statements is the Notes to Financial Statements section. This is where you and other readers will find information on the breakdown of various line items on the balance sheet and income statement. If you're profitable and really want to go ballistic, take a look at how much cash you paid out in the year for income taxes. Generally accepted accounting principles require this information be disclosed in the financial statement. And don't say we didn't warn you; you may be in for a big surprise.
Sometimes bankers, investors or even owners like to see other information in the financial statements. Schedules of sales by division or income statements by division or some other appropriate breakdown can be useful in assessing overall operations. Since this information is not generally required by accounting rules or regulations to be part of the "basic statements," it is put in an area called Supplemental Information. Again, the data presented in this area is usually just a more detailed analysis of information already presented in the basic financial statements.
Now, with the basics out of the way, let’s take a look at what the balance sheet can show about your business. And, just so to avoid sounding like we're in Accounting 101, we'll assume you already know the basic parts of a balance sheet and launch right into the more meaty stuff.
A key factor for any business is, obviously, working capital. You can determine what your working capital is by taking the total of your current assets and subtracting the total of your current liabilities. And your hope (and ours), of course, is that you wind up with an excess of current assets over current liabilities, which indicates you're able to meet your obligations as they come due.
Another way bankers, accountants, and business owners calculate working capital is by using the Quick Ratio and the Current Ratio.
The Current Ratio simply takes the total of current assets and divides it by the total of current liabilities. Anything over 1 indicates you have enough assets to pay off current liabilities as they come due. Anything less than 1 indicates you may be in, or headed for a cash crunch.
The Quick Ratio takes a much closer look at your ability to pay debts as they come due. Instead of using the total of current assets, you basically use only cash and other current assets that can be turned into cash quickly such as short-term investments, accounts receivable, short-term receivables, etc. Current assets that are illiquid, such as inventories, are excluded from the ratio. To get the Quick Ratio, the total of the assets, which can be converted quickly to cash, is divided by the current liabilities. With this Ratio, you can generally afford to have less than a ratio of 1 and still be in good financial shape. However, a ratio of 1 or greater is preferable.
Closely akin to the Quick Ratio is the Inventory to Net Working Capital Ratio. As it’s name implies, this ratio will tell you how much of your working capital is invested in inventory. This can be a very handy figure because it can tell you if you may have too much or too little inventory.
You and your advisors can gain a greater understanding of your business by comparing these ratios as they change over time. For example, if you find that your Quick Ratio has remained at a relatively good level for each of the past five years, but has been steadily declined over the last year, you may have an inventory problem or a cash management problem. Perhaps you're carrying too much inventory for your size of business or perhaps some of the inventory is no longer salable. Perhaps you're paying bills too fast. Whatever the case, a comparison of these ratios from year-to-year will alert you to possible problems.
Your banker will also look at your Debt to Equity Ratio. Simply put, this ratio is total liabilities (current and long-term) divided by stockholder’s or owner’s equity. This is a measure of how leveraged you are. Being highly leveraged basically means you have a great deal of debt. If you are, what are the implications for your future earnings capacity? And more important to the banker is how much of the business do you own versus what your creditors own? As far as the banker is concerned, the higher the Debt to Equity Ratio, the riskier the loan.
As with the other ratios we've discussed, comparing Debt to Equity Ratios from year-to-year can also yield a very valuable perspective on your business. A steadily increasing Debt to Equity Ratio could indicate looming liquidity problems (Cisco is a case in point). A steadily decreasing Debt to Equity Ratio could be good or bad depending on how you want to handle your business. If you're comfortable keeping capital in your business and this is where you can maximize your investment return, then by all means, get the Debt to Equity Ratio as low as possible. However, by holding too much capital in your business, you could be missing out on more lucrative opportunities.
Once you've derived all the ratios mentioned above, a very skillful way to utilize them for managing your business is to compare them with industry averages. The information we've presented is general in nature and may not be applicable to every business. Perhaps you're in an industry that works best in a highly leveraged environment or a Quick Ratio of 1 is really mediocre in your industry.
Your banker will most likely be able to help you determine which ratios are most useful for your specific situation. And to further educate yourself on the use of these ratios, you can ask your banker for a copy of The Risk Management Association Annual Statement Studies. Comparison of your company’s ratios to those of your peers can be a big help in assessing the health of your business.
As you can see, the Balance Sheet is more than just a few numbers that the banker likes to see. We'll continue this conversation next month with income statement analysis. Until then, don’t be a stranger. As business advisors, we have the training and expertise to sit down with you and discuss your financial condition. We can show you how to use your financial statements to manage your business.
May 2002 be a happy and prosperous year for you and your loved ones.