Thank you Ben Pumphrey for today’s post.
In Part 1 of Why Financial Analysis is Essential in Any Business we addressed the conundrum that “making a nice profit” and “doing well” is simply a starting point. I pointed out that one of the Key Responsibility Areas (KRA’s) for setting business metrics is financial performance.
Unfortunately, companies and not-for-profit organizations often develop their strategic planning without a clear understanding of their financial performance. This lack of focus on hard-core business analytics has companies disappearing in no time, or in the best case scenario move along with the herd without significant relevance and growth.
In this discussion we will cover some basics in the other two of the four (4) areas of financial analysis, Profitability Ratios and Activity Ratios.
- Profitability Ratios: Profitability ratios measure a firm’s ability to generate profits and to a certain degree management’s effectiveness and are calculated from data in both the income statement and balance sheet. Return on Assets (also known Return on Investment) is one of the standard acid tests as it tells how much income is being generated by the assets employed. The calculation is Net Income / Total Assets. Often times the Return on Sales calculation provides more strategic and tactical information as it shows how much profit is generated for each dollar in sales. Pricing strategies can be formed from this information. The calculation is Total Sales / Net Income. Other standard profitability calculations include Return on Net Worth and Earnings per Share.
- Activity Ratios: Activity Ratios demonstrate how well a company is managing its resources. The results of this type of financial analysis if often where the low hanging fruit lies in setting metrics and strategies to improve a company’s performance. Activity ratios are divided into two categories, Turnover Ratios and Cost Ratios. I will discuss a couple of ratios in each category.
- Turnover Ratios: Inventory Turnover is a very important ratio for any retail based firm as it defines does it have the correct amount of inventory on hand. Too high ratio means a company might be leaving sales on the table and too low a number means that warehousing and other inventory associated costs are probably resulting in higher that desired overhead costs. The calculation is Total Sales / Total Inventory. Another important turnover ratio for most businesses is Average Collection Period. It answers the question of how long is it taking to collect on accounts receivable. This ratio varies significantly by industry from 0 days for fast food restaurants to months for certain service industries. The calculation is Total Accounts Receivable / Total Sales / 360 Day.
- Cost Ratios: The most common cost ratio is the Cost of Goods Sold (COGS) ratio. The COGS ratio is the other side of the coin to the Gross Margin Ratio. The calculation is Total COGS / Total Sales. I highly recommend digging in much deeper when looking at COGS. Begin by taking a look at how your cost of goods sold match up to industry paying close attention to direct labor hours, cost of materials and subcontractor costs. The other very common cost ratio is the Operating Cost Ratio. This ratio reveals how well the operations of the company are performing especially when compared to an industry average. The calculation is Selling, Administrative and General (SG&A) Costs / Total Sales.
So why is Financial Analysis Essential?
When a company commits to doing the hard work of performing financial analysis rigorously and reviewing results on regular intervals management is assuring that not only is the company profitable but that they are targeting the right activities with the correct amount of resources needed to first of sustain its position in the market and to create tactics to grow its market share into the future. I strongly recommend quarterly financial reviews as part of a larger company level strategic performance review with the planned result of updating existing financial metrics and establishing other financial metrics based on the information.
Below is a list of the most common financial ratios to help you get started.
Formula Key – Financial Ratios
| Current Ratio | = | Total Current Assets / Total Current Liabilities |
| Quick Ratio | = | (Cash + Accounts Receivable) / Total Current Liabilities |
| Gross Profit Margin | = | Gross Profit / Sales |
| Net Profit Margin | = | Adjusted Net Profit before Taxes / Sales |
| Inventory Days | = | (Inventory / COGS) * 365 |
| Accounts Receivable Days | = | (Accounts Receivable / Sales) * 365 |
| Accounts Payable Days | = | (Accounts Payable / COGS) * 365 |
| Interest Coverage Ratio | = | EBITDA / Interest Expense |
| Debt-to-Equity Ratio | = | Total Liabilities / Total Equity |
| Return on Equity | = | Net Income / Total Equity |
| Return on Assets | = | Net Income / Total Assets |
| Fixed Asset Turnover | = | Sales / Gross Fixed Assets |
| Profit Growth | = | (Current Period Adjusted Net Profit before Taxes – Prior Period Adjusted Net Profit Before Taxes) / Prior Period Adjusted Net Profit before Taxes |
| Sales Growth | = | (Current Period Sales – Prior Period Sales) / Prior Period Sales |
| Sales per Employee | = | Sales / Total Employees (FTE) |
| Profit per Employee | = | Adjusted Net Profit before Taxes / Total Employees (FTE) |
Many if not most hold a fundamental belief that the economy drives growth and profit and they strategies must be aligned with the ebb and flow of the greater economic forces, an answer straight out of a textbook on orthodox capitalism.
Surely the question and answer are familiar to you, because we consciously and unconsciously think about it all the time. Unfortunately, companies and not-for-profit organizations often develop their strategic planning, and even sometimes their business model, based on economic trends. This type of focus has companies disappearing in no time, or in the best case scenario move along with the herd without significant relevance and growth.
I ask you to think a bit deeper. Could the capitalist model really have survived all this time if was really the case that organizational growth and profitability were tied primarily to macro-economic or for that matter micro-economic trends?
Interestingly enough, studies have shown that economic forces play less in the success of companies and organizations to thrive and grow than you may think.
What we now know is that organizations that grow and profit year after year apply a different philosophy, one that we at FocalPoint call “The Way to Wealth”. The methodology is based on the principal of compounding and focuses on four (4) key management formulas to attract new customers, drive revenue growth and generate higher profitability. What’s more these principals work for any organization.
Buried beneath the surface of these four formulas are nearly 600 methods that can be applied to increase the number customers, revenue, gross profit and net profit.
From this strategic point of view, the importance is in making sure that the company’s plans are all oriented in the same direction. Not only are they making money, but also assuring that their company will sustain its position in the market for the long term. Rigorously applying the disciplines in the Way to Wealth methodology will help your company or organization ensure that the strategies, plans and daily activities are all in alignment thus delivering both short term and long term benefits regardless of the economic outlook. In other words you ride the wave higher in a strong economy and are affected much less in a downward trending economy.