Just about any accountant you talk to will stress the importance of timely financial information in managing your business. Your balance sheet and income statement can tell you a great deal about the health of your company - its past and perhaps even its future. Comparing operating results to prior periods is invaluable, as is comparison with other companies in your industry. This monthÂÂ’s article will focus on operating results and industry data for you to consider.
Significant operating ratios
Current Ratio - this is essentially a measure of your company's ability to pay bills as they come due. It is calculated by dividing your total current assets (cash, accounts receivable, inventories, short-term investments and prepaid expenses) by current liabilities (accounts payable, expense accruals, current portion of long-term debt). While there is no hard and fast rule as to what your current ratio should be, one of less than 1:1 is not desirable. The higher the ratio, the better off you are.
Quick Ratio - this is also a measure of your company's ability to pay bills as they come due. It further refines the quick ratio by eliminating all but the most liquid of assets. In the calculation, prepaid assets and inventories are eliminated from current assets. In effect, it provides a measure of your companyÂÂ’s ability to pay bills immediately.
Days Sales in Receivables - this tells you how quickly you are collecting amounts due your company. This ratio divides the total receivables by average daily sales. Here is an example: you had receivables of $36,500 and annual sales were $365,000, so the calculation would be [36,500/ (365,000/365)] or 36.5. This number can fluctuate widely by industry.
Days Cost of Sales in Inventory - this tells you how well you are managing inventory. The calculation is similar to days sales in receivables, except the numerator is inventory and the denominator is average cost of sales. This ratio can also fluctuate widely from industry to industry. Inventory turnover is very closely related. For example, assume cost of sales is $3.65 million and inventory is $365,000. This means that days cost of sales in inventory is 36.5. Inventory turnover is $3.65 million/$365,000 or 10 times. You can reach the same ratio by dividing 365 days by the days cost of sales in inventory of 36.5.
Days Purchases in Accounts Payable - this tells how current your payables are. Calculated by dividing accounts payable by average daily purchases, this ratio, when compared to normal payment terms, will tell you whether you are paying your bills currently or not.
Debt to Equity - this helps you determine how well your company manages debt. The calculation is based on total debt, including normal trade payables, divided by your equity in the company. This ratio helps you determine how much of the company's assets are financed internally and externally. This ratio can heavily influence company value.
Gross Profit on Sales - this tells you how much of each sales dollar is available to cover expenses other than the cost of acquiring or producing the item sold. This ratio is highly dependent on a company's industry. The calculation basically subtracts cost of sales from sales. This number is then divided by sales.
Net Income to Sales - this tells you how well you manage your costs and expenses. Just like gross profit, this ratio can vary widely by industry.
Your first and most important data source for operating statistics is your own financial statements. Prior months' or years' ratios compared to current results will help you understand if your operating philosophy is working. This comparison will allow you to see if the business is headed in the right direction or whether you need to change operations to achieve the results you want.
Secondly, many trade groups maintain operation data. Whenever possible, join appropriate groups and leverage their knowledge on how to run your business. Statistics maintained by professional or trade organizations are likely to be the most accurate. Be sure to obtain information about companies similar to yours in size and operations.
Outside data firms such as Robert Morris Associates and BizStats provide industry ratios ÂÂ– usually for a price. They provide high-quality information for a generally reasonable cost. You also might be able to get some information from your banker.
Effective review of your financial statements and comparison to your peers can be invaluable in managing your business. Many research agencies provide high-quality data at reasonable prices to help you compare your operations to others, but you need to make certain that you are comparing apples to apples. Give us a call and let us help you design an appropriate financial monitoring system for your business.
Have a great May.