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Financial Ratios for Shop Evaluation

Don't neglect these tools in evaluating your company.

You probably spend a lot of time analyzing your business. Far too many shop owners, however, neglect one of the best ways to evaluate a company: the use of financial ratios"?including liquidity ratios, profitability ratios, and activity ratios.

Before getting into the details, let's consider how these ratios should be used. The most useful analysis is achieved by comparing the results of your financial analysis over different periods of time. For example, ratio analysis on your annual financial statements should be discussed in the context of how things have changed since the prior year. In addition, comparative analysis also can be done on a quarterly and a monthly basis if you wish to more accurately track the financial health of your company.

You can also use financial ratios to evaluate the performance of your business against standards that have been established in your company's specific market niche (to the extent that the information is available). Comparing and contrasting the results of your business with industry norms can be a very useful tool in financial benchmarking. Keep these thoughts in mind as I take you through a few ratios that should prove useful.

Liquidity ratios

Liquidity ratios measure the extent to which a company can quickly liquidate its assets and generate cash in order to cover short-term liabilities.

Current Ratio = current assets ?? current liabilities

This ratio measures how well a company can manage its shortterm cash needs. Simply stated, can the company pay its bills? If this ratio is substantially over 1.0, cash flow will typically be positive and working capital will be available for the day-to-day business needs. If, however, this ratio dips below 1.0, cash flow will become tight and the business may begin to suffer from a cash crunch.

Quick Ratio = quick assets (current assets - inventories) ??current liabilities

The quick ratio is often used by banking and financial institutions to measure true liquidity. Because inventories are less easily converted to cash, the quick ratio provides a more accurate measure of the business's ability to meet immediate cash-flow demands.

Profitability ratios

Profitability ratios generally show how successful a company is in terms of generating returns or profits on the investment that it has made in the business.

Profit Margin = net income ?? sales

This ratio is probably the most popular and widely utilized of all ratios. The measure of net income generated by sales is always an important number to focus on when managing a business. This ratio provides the snapshot of any company's fiscal health.

Return on Assets = net income ?? average total assets [(beginning assets + ending assets) ?? 2]

This ratio indicates asset utilization by a business in terms of income generated. For example, if a business increases profitability from 6% to 8%, that would indicate a positive trend. If, however, the business doubled its assets in that same year but only increased profitability by 2 points, the return on assets will show a negative trend and unfavorable results. This ratio will identify companies that are purchasing significant assets to maintain their profit margins.

Return on Equity = net income ?? average shareholders' equity [(beginning shareholders' equity + ending shareholders' equity) ?? 2]

This ratio is very similar to the return on assets. The return on equity will indicate the measure of profitability as a proportion of the amount of equity infused into the company. If the company's owners contribute a significant amount of equity to the business in order to provide working capital, inventory, assets, etc., and the profit margin remains the same, this ratio may indicate that equity is perhaps not being utilized as well as you would like"?especially if you are the contributor!

Activity ratios

Activity ratios measure a company's ability to utilize cash and inventory to generate sales.

Accounts Receivable Turnover Ratio = sales ?? average accounts receivable [(beginning A/R + ending A/R) ?? 2]

In addition to tracking your A/R aging reports, try calculating the A/R turnover ratio on a regular basis and chart the progress. While the A/R aging report provides an immediate snapshot of where your collection efforts should be focused, the A/R turnover ratio illustrates how effective your collection efforts are.

For example, at the end of a given month, your work on collecting outstanding accounts might indicate an improvement in the overall balance of accounts receivable. This is good! If, however, sales have dropped down in that same month by a larger amount, the A/R turnover ratio calculation will indicate that collection efforts need to improve. This ratio presents you with an overall picture of how well the collection efforts are going in relation to the increase or decrease of sales in a given month.

Inventory Turnover Ratio = cost of goods sold ??average inventories [(beginning inventories + ending inventories) ?? 2]

The inventory turnover ratio offers valuable data regarding the purchasing levels of inventory. It provides valuable insight regarding inventory utilization. Like the other ratios, this calculation is best used when comparing with other periods. If this ratio is tracked for an extended period of time, you can then begin to target the turnover ratio desired, and measure results accordingly.

Indicating the trends

Remember: By themselves, these financial ratios serve no useful purpose"?their job is to indicate trends in the financial position of your company. Using financial-ratio analysis requires discipline and some time, but if you use it, you will gain a better understanding of your business"?which should make you a better manager.

Marty McGhie (marty@ferraricolor.com) is VP finance/ operations of Ferrari Color, a digital-imaging center with Salt Lake City, San Francisco, and Sacramento locations.

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