The Essentials of Finance and Accounting for Nonfinancial Managers By Edward Fields

1
The Essentials of Finance and Accounting for
Nonfinancial Managers By Edward Fields

• Chapter 6
• Key Financial Ratios

2
Introduction

• Ratios are mathematical calculations used to
  evaluate performance
• Display trends over time to indicate improving or
  deteriorating conditions
• A Ratio compares one or a set of numbers against
  the same
• Beneficial to compare current year with previous
  year
• Or current month with previous months

3
Statistical Indicators

• Common key business statistical indicators
• Output per labor hour
• Market Share
• Sales Orders
• As a total
• Per Salesmen
• Responses from mailings
• 10,000 offers sent received 125 inquiries (1.25)

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Statistical Indicators

• Business measures monitored
• Hourly
• Daily
• Weekly
• Monthly
• Semi-annual
• Annually
• Internal management function
• Measures may result in resource changes
• Increasing/decreasing labor
• Machine adjustments
• Material ordering frequency

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Financial Ratios

• Provide company overview
• Manage and monitor company performance
• Full appreciation and proper use requires the
  analyst
• Understand the business
• Analysis within the context of current economic
  climate
• Awareness of legal and regulatory issues
• Knowledgeable of industry averages

6
Financial Ratios

• Those interested in ratios
• External
• Potential and existing stockholders
• Bankers and lenders
• Competitors
• Internal
• Board of Directors
• Senior management
• Strategic partners

7
Financial Ratios

• Four major groupings
• Liquidity ratios
• Working capital management ratios
• Measures of profitability
• Financial leverage ratios

8
Liquidity Ratios

• Liquidity measures are used to evaluate a
  companies ability to pays its bills on a regular
  basis
• Measured by two ratios
• Current Ratio
• Quick or Acid test ratio

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Current Ratio

• Compares current assets with current liabilities
• A ratio below 1.0 means current assets are less
  than current liabilities.
• A clear indication of liquidity problems
• A ratio above 1.0 does not mean the company is
  adequately liquid.
• Current assets can be skewed high due to
• Poor inventory management and thereby too much
  inventory
• Poor job collecting accounts receivable

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Current Ratio
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Quick Ratio Acid Test

• Same as current inventory but does not include
  inventory
• Must be understood that there is a great
  difference between accounts receivable and
  inventory
• Accounts receivable
• All work has been done and product has been
  delivered
• Inventory
• Work remains
• Raw material
• Work in process completion
• Inventory is not as liquid as accounts receivable

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Quick Ratio Acid Test
13
Ratio Exceptions

• Exceptions exist for calculated ratios
• Pure formulaic analysis can never replace a
  combination of formulaic analysis coupled with
  knowledge
• For example a company had a sound current ratio,
  but
• Finished good inventory on hand (Inventory) was
  manufactured to wrong specifications and hence
  rejected by the customer

14
Working Capital Management Ratios

• Assist the company in evaluating its performance
  regarding management of credit
• Days Sales Outstanding
• Measures the average number of days the company
  takes to collect accounts receivable

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Days Sales Outstanding

• When credit is extended, customers have the
  opportunity to pay later rather than on receipt
• Extending credit helps to sell the product
• Offering credit is a competitive advantage
• Not offering credit would almost assure sending
  customers to competitors who offer credit

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Days Sales Outstanding

• If average days sales outstanding is 43 days on
  average, this means it is taking that many days
  to collect funds due
• This ratio should be compared to credit terms
  offered by the company
• For example credit terms may be
• 2/10 net 30 or
• 3/15 net 45

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Days Sales Outstanding
2002
2001
Assume credit terms are 2/10 net 30
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Aging of Receivables

• An aging of accounts is a detailed listing of how
  long the company has been waiting for payment

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Receivables Management

• Reducing receivables without negatively effecting
  sales is a vital management function
• The following are some general strategies. Not
  every one will work for every business
• However, a business absent a receivables strategy
  will likely result in financial disasters

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Receivables Management

• Be aware that credit is a sales tool
• Never make the extension of credit automatic
• Extend credit if the customer asks and they
  deserve it
• Train customers to pay fast
• Get the clock ticking
• Never apologize for asking for money
• Search for opportunities to reduce your
  outstanding receivables

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Inventory Turnover Ratio

• Provides an overview of how the company manages
  one of it most valuable assets Inventory
• Inventory interpretation is as follows
• Turnover of 12 times translates into one months
  inventory on hand, on average
• Turnover of 6 times translates into two months
  inventory on hand, on average
• Another definition The number of times a
  business turns over or sells inventory during the
  year

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Inventory Turnover Ratio
Generally, the inventory figure used is the
average of the beginning and ending inventories.
In this example, for simplicity. The ending
inventory was used.
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Measures of Profitability

• Assist management in evaluating
• Profitability achieved by management team
• Assets invested in the business
• Revenue achieved
• Funds that the owners have invested in the
  business

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Gross Profit Percentage

• Measures the performance of profit earned
  relative to revenue (sales)
• The resultant percentage is dependent on the
  industry
• 34 is very good for manufacturing
• 20 to 25 is very good for warehouses
• 60 to 70 is a acceptable range for medical
  products

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Measures of Profitability

• Return on Assets
• Measures the profitability of the company
  relative to the total amount of assets the owners
  have invested in the business
• Return on Equity
• Measures the companies ability to use borrowed
  funds effectively as well as the owners money

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Measures of Profitability
RETURN ON ASSETS
2001
2002
ROA
4.9
6.6
RETURN ON EQUITY
2002
2001
ROE
10.0
7.8
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Measures of Profitability

• Return on Sales
• Measures the overall efficiency of the company

2001
2002
4.9
3.75
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Financial Leverage Ratios

• Borrowing funds to finance expansion is a
  positive business strategy
• The optimal business result is to receive the
  benefits of debt before the debt become due
• When too much of the debt becomes due before
  sufficient benefit is generated, serious cash
  flow problems will result

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Debt to Equity Ratio

• Measures the risk from the perspective of both
  the company and lenders

30
Interest Coverage

• Describes the cushion the company has between the
  amount of cash it generates before interest
  expense and taxes and the amount of interest for
  debt