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Analyzing Financial Statements, Part 2

Originally published: 05.01.07 by Ruth King


Analyzing Financial Statements, Part 2

Use these metrics to measure your company's financial health.

In Part One, I began describing the 10 financial ratios that you must calculate each month to help you spot minor issues before they become major crises. Here are the rest of the ratios.

Accounts Receivable-to-Accounts Payable (AR/AP)

The AR/AP ratio is a measure of liquidity. You calculate it by looking at the balance sheet, as follows:

Accounts receivable
Accounts payable

Be careful to include only trade receivables and trade payables; that is, receivables from customers and payables to supplies. Do not include any receivables or payables from employees, officers, friends, relatives, and the like.

If 50 percent or more of your sales are cash-on-delivery (COD), then use accounts receivable plus cash divided by accounts payable to calculate this ratio.

The ratio should be 2 or higher. A ratio less than 1 indicates that sales and receivables are not high enough to cover what is owed to suppliers — which means your company probably is in trouble. If this is the case, then look at pricing very carefully. You are not charging enough to cover daily expenses. You are "robbing Peter to pay Paul." If that continues, you will not be able

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to pay payroll and other weekly expenses.

To improve the ratio, and the health of your business, you must use the inventory on the trucks and in the shop, increase your closing ratio on replacement sales (if possible), increase sales volume, and raise prices immediately.

Debt-to-Equity

The debt-to-equity ratio measures the capitalization of the company. It looks at how much debt your company has in relationship to the worth of the company. If you have a negative net worth, it means that you have more debt than you have assets to cover the debt. It usually means that the company has not been profitable. You must turn the company around if you want it to survive.

Most contracting companies are undercapitalized, which means that the majority of money that has been invested in it comes from loans. You calculate this ratio by looking at the balance sheet. It is calculated:

Total liabilities
Equity

Total liabilities include both short- and long-term liabilities. Long-term liabilities are debts that the company has incurred that are more than a year in length. These usually include vehicles, building(s), and investor loans. Total equity includes stock invested, paid-in capital, and retained earnings.

This ratio should be as low as possible, but definitely not negative! For most contracting companies it is around 2 to 3.

A negative debt-to-equity ratio means the company's net worth is negative. Very few bankers will extend loans to a company with a negative net worth unless there are extenuating circumstances, and there are assets that the company can pledge. A negative net worth means that the company probably is in trouble because it has been losing money for a long time.

To improve the debt-to-equity ratio (to make it smaller), you must increase profit. This means increasing the number of profitable jobs and increasing productivity.

Long-Term Debt-to-Equity

The long-term debt-to-equity ratio also is a measure of capitalization. You calculate this ratio by looking at the balance sheet. It is calculated:

Long-term liabilities
Total equity

Again, make sure that items that should be listed in long-term liabilities are included. If you have bank loans and no current portion of these loans is listed, then this ratio will be overstated.

This ratio should be less than 1, but 0 or greater. It should definitely not be negative! (See the explanation for debt-to equity.) Some contracting companies have no long-term liabilities, and that is O.K. They pay cash for all of their assets and don't owe a bank for anything. For such companies, this ratio will be 0.

I have a tendency to put a low importance on the debt-to-equity ratio unless it is negative. Most hvac companies are undercapitalized, which means that more debt than cash was used to start and grow the business; this shows up in these two ratios. If the company is liquid and not losing money, I place more emphasis on the liquidity of the company rather than its debt-and-equity structure. If the current ratio, acid test, AR/AP, percentage compensation, and long-term debt-to-equity ratios are within industry standards, I discount a high debt-to-equity ratio. Even if it is high, the company still has the liquidity to pay its bills on time.

Inventory Turns

Inventory turns measure how efficiently the company uses its inventory. The turns are calculated on annual costs. Calculate this ratio by using both the income statement and the balance sheet. It is calculated:

Annualized Cost of Goods Sold (COGS)
Inventory

To annualize the COGS, use the year-to-date figures on your income statement. For example, if you have total COGS for a quarter, then multiply this figure by 4 to get the estimated annual COGS.

The banks calculate this ratio differently. They use annualized material expense rather than annualized COGS. However, I don't know any company in our industry that can install a part without labor, so I include both. The average results reflect the annualized COGS rather than material expense.

Inventory turns should be between 6 and 12 times per year. If it is greater than 24, the company may be running to the parts house too frequently (and increasing unapplied labor and other expenses, etc.). If it is under 6, the company probably is keeping too much inventory on hand.

If these figures are out of line, it is also possible that the inventory figure is overstated, or the company has inventory that is unusable. In either case, a physical inventory should be taken to determine the true inventory level, and the unusable inventory should be written off.

Inventory days

This financial ratio measures how long an average piece of inventory stays in the shop before it is used. You calculate this ratio from the inventory-turn number. It is calculated:

365
Inventory turns

The result should be under 30 days. If you are a commercially based company the inventory days can be as low as five days without problems.

Receivable Turns

This figure measures how efficiently the company keeps track of its receivables. The turns are calculated on annualized sales. Calculate this ratio by using both the income statement and the balance sheet. It is calculated:

Annualized sales
Accounts receivable

If you included cash in the AR/AP ratio, then you have to add cash to accounts receivable in this ratio.

To annualize sales use the year-to-date figures. For example, if you have total sales for a quarter, multiply this figure by four to get the estimated annual sales.

This figure should be 6 or greater. Anything less than 6 means that the company has a receivable problem. You must address this issue and work toward getting receivables current or within 45 to 60 days.

Receivable Days

The receivable days measures how efficiently the company collects its receivables. The days are calculated from the receivable turns figure. It is calculated:

365
Receivable turns

This figure should be less than 60 days, but preferably lower than 45 days. If it is larger, then see the explanation for receivable turns. If your company mainly works COD, your receivable days are near 0. If the receivable days are greater than 30, then you have a collection problem.

Also, the inventory days should be less than the receivable days. If the number is greater, then you may have an inventory problem.

Percentage compensation

This ratio measures the productivity of your employees. It is calculated:

Total payroll expenses plus payroll taxes
Sales

Compensation consists of direct labor, office salaries, officer salaries, sales people's salaries, and payroll expenses (FICA, Medicare, unemployment, and local/city payroll tax). It does not include worker's compensation, health insurance, or cafeteria-plan expenses.

Your company's total compensation as a percentage of total sales should not exceed 20 percent if you perform mainly new construction work. If your company does mainly service and replacement, it should be under 30 percent. If you only do service work, this ratio should be less than 40 percent. If the percentage compensation is too high, find the department where the compensation is high and determine whether you can cut payroll or if you need to grow that department's revenues.

Summary

One month's financial ratios alone are not going to tell you much. However, over time you should be able to spot trends. If something looks wrong, do something about it before a minor problem becomes a major crisis. You want to see your current ratio, acid test, and AR/AP ratio increasing or remaining the same. You want to see your debt-to-equity ratio and long-term debt-to-equity ratio decreasing or staying the same (but always above 0). Receivable days and inventory days should be stable, with receivable days greater than inventory days.

If you are generating accurate, timely financial statements, and the ratios are in line, you know that your company probably is healthy. If the ratios aren't in line, then do something about them so that you won't have financial difficulties.


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