Leverage Ratios. Leverage ratios measure the financing supplied by the firm's owners against that supplied by its creditors; they are a gauge of the depth of a company's debt. These ratios show the extent to which an entrepreneur relies on debt capital (rather than equity capital) to finance operating expenses capital expenditures, and expansion costs. As such, it is a measure of a company's degree of financial risk. Generally, small businesses with low leverage ratios are less affected by economic downturns, but the returns for these firms are lower during economic booms. Conversely, small firms with high leverage ratios are more vulnerable to economic slides, but they have greater potential for large profits
Debt Ratio. The small firm's debt ratio measures the percentage of total assets financed by its creditors. The debt ratio is calculated as follows:
Debt Ratio = Total debt (or liabilities)
Total assets
= 367,850 + 212,150
847,655
= 0.68
Total debt includes all current liabilities and any outstanding long—term notes and bonds. Total assets represent the sum of the firm's current assets, fixed assets, and intangible assets. Clearly, a high debt ratio means that creditors provide a large percentage of the firm's total financing. Owners generally prefer a high leverage ratio; otherwise, business funds must come either from the owners' personal assets or from taking on new owners, which means giving up more control over the business. Also, with a greater portion of the firm's assets financed by creditors, the owner is able to generate profits with a smaller personal investment. However, creditors typically prefer moderate debt ratios since a lower debt ratio indicates a smaller chance of creditor losses in case of liquidation. To lenders and creditors, high debt ratios mean a great risk of default.
According to a senior analyst at Dun & Bradstreet's Analytical Services, "If managed properly, debt can be beneficial because it's a great way to have money working for you. You're leveraging your assets, so you're making more money downfall. "As we pile up debt on our personal credit cards our lifestyles are squeezed," he says. "The same thing happens to a business. Overpowering debt sinks thousands of businesses each year."
Debt-to-Net-Worth Ratio. The small firm's debt to net worth ratio also expresses the relationship between the capital contributions from creditors and those form owners. This ratio compares what the business "owes" to what it "owns." It is a measure of the small firm's ability to meet both its creditor and owner obligations in case of liquidation. The debt to net worth ratio is calculated as follows:
Debt to net = Total debt (or liabilities)
worth ratio Tangible net worth
= 367,850 + 212,150
267,655 – 3,500
= 2.20
Total debt is the sum of current and long-term liabilities, and tangible net worth represents the owners' investment in the business (capital + capital stock + earned sir[;is + retained earnings) less any intangible assets (e.g., goodwill) the firm owns.
The higher this ratio, the lower the degree of protection afforded creditors if the business should fail. Also, a higher debt to net worth ratio means that the firm has less capacity to borrow; lenders and creditors see the firm as being "borrowed up." Conversely, a low ratio is typically associated with a higher level of financial security, giving the business greater borrowing potential.
As the firm's debt to net worth ratio approaches 1 to 1, the creditors' interest in the business approaches that of the owner's. If the ratio is greater than 1 to 1, the creditors' claims exceed those of the owners', and the business may be undercapitalized. In other words, the owner has not supplied an adequate amount of capital, forcing the business to be overextended in terms of debt.
Times Interest Earned. Times interest earned is measure of the small firm's ability to make the interest payments on its debt. It tells how many times the company's earnings cover the interest payments on the debt it is carrying. The times interest earned ratio is calculated as follows:
Earnings before interest and taxes
Times interest = (or EBIT)
earned Total interest expense
= $60,629 + $19,850
19,850
= 4.05
EBIT is the firm's profit before deducting interest expense and taxes; the denominator measures the amount the business paid in interest over the accounting period.
A high ratio suggests that the company would have little difficulty meeting the interest payments on its loans; creditors would see this as a sigh of safety for future loans. Conversely, a low ratio indicates that the company is overextended in its debts; earnings will not be able to cover its debt service if this ratio is less than one. "I look for a {times interest earned} ratio of higher than three-to-one," says one financial analyst, " which indicates that management has considerable breathing room to make its debt payments. When the ratio drops below one-to-one, it clearly indicates management is under tremendous pressure to raise cash. The risk of default or bankruptcy is very high." Many creditors look for a times interest earned ratio of at least four to six before pronouncing a company a good credit risk.
Trouble looms on the horizon for companies whose debt loads are so heavy that they must starve critical operations—research and development, customer service, and others—just to pay interest on the debt. One textile maker that took on a huge debt load to go private in an LBO is still feeling its effects. "Once you're as highly leveraged as we are," says the company's chairman, "you just can't do anything that takes cash, whether it's acquisitions or capital spending."
Debt is a powerful financial tool, but companies must handle it carefully—just as a demolitionist handles dynamite. And, like dynamite, too much debt can be dangerous. In the 1980's U.S. companies went on a borrowing binge. Unfortunately, some of those debtors who pushed their debt loads beyond the safety barrier (see fig. 1.6)are struggling to survive in the 1990's. Many well-known companies that have overloaded on debt—Foster Grant (sunglasses) and Ames Department Stores and Carter Hawley Hale (retail)—have declared bankruptcy. Managed carefully, however, debt can boost a company's performance and improve its productivity. Its treatment is the tax code also makes debt a much cheaper means of financial growth than equity. When AA-rated companies borrow at 9.2 percent, the after-tax cost is just 6.6 percent (because interest payments to lenders are tax deductible): equity financing costs more than twice that "You need a 14 percent return to satisfy your shareholders and keep up your stock price," says a CEO.
Operating Ratios. Operating ratios help the owner evaluate the small firm's performance and indicate how effectively the business employs its resources. The more effectively its resources are used, the less capital a small business will require. These five operating ratios are designed to help an entrepreneur spots those areas she must improve if the business is to remain competitive.
Average Inventory Turnover. The small firm's average inventory turnover ratio measures the number of times its average inventory is sold out, or turned over, during the accounting
Fig 1.6. How much debt?
period. This ratio tells the owner whether the firm's inventory is being managed properly. Its apprises the owner or whether the business inventory is understocked, overstocked, or obsolete. The average inventory turnover ratio is calculated as follows:
Average inventory = Cost of goods sold
turnover ratio Average inventory
= 1,290,117
(805,745 + 455,455)/2
= 2.05 times/year
Average inventory is found by adding the firm's inventory at the beginning of the accounting period to the ending inventory and dividing the result by 2.
This ratio tells the owner how fast the merchandise is moving through the business. To determine the average number of days unit remain in inventory, divide the average inventory turnover ratio into the number of days in the accounting period (e.g., 365/average inventory turnover ratio). The result is called days' inventory. An above-average inventory turnover indicates that the small business has a healthy, salable, and liquid inventory and a supply of quality merchandise supported by sound pricing policies. A below-average inventory turnover suggests an illiquid inventory characterized by obsolescence, overstocking, and stale merchandise.
Businesses that turn their inventories more rapidly require a smaller inventory investment to produce a particular sales volume. That means that these companies tie up less cash in inventory that idly sits on shelves. For instance, if Sam's could turn its inventory four times each year instead of just two, the company would require an average inventory of just $322,529 instead of the current level of $630,600 to generate sales of $1,870,841. Increasing the number of inventory turns would free up more than $308,000 currently tied up in excess inventory? Sam's would benefit from improved cash flow and higher profits (see fig. 1.7).
Fig 1.7. The effect of turnover on profits. Source: Retail Merchandising Service Automation, Inc.
The inventory turnover ratio can be misleading, however, For example, an excessively high ratio could mean the firm has a shortage of inventory and is experiencing stockouts. Similarly, a low ratio could be the result of planned inventory stockpiling to meet seasonal peak demand. Another problem is that the ratio is based on an inventory balance calculated form 2 days out of the entire accounting period. Thus, inventory fluctuations due to seasonal demand patterns are ignored, which may bias the resulting ratio. There is no universal, ideal inventory turnover ratio. Financial analysts suggest that a favorable turnover ratio depends on the type of business, its size, its profitability, its method of inventory evaluation, and other relevant factors. Average Collection Period. The small firm's average collection period ratio tells the average number of days it takes to collect accounts receivable. To compute the average collection period ratio, you must first calculate the firm's receivables turnover. If Sam's credit sales for the year were $1,309,589, then the receivables turnover ratio would be as follows:
Receivables = Credit sales (or net sales)
turnover Accounts receivable
= 1,309,589
179,225
= 7.31 times/year
This ratio measures the number of times the firm's accounts and notes receivable turn over during the accounting period. Sam's Appliance Shop turns over its receivables 7.31 times per year. The higher the firm's receivables turnover ratio, the shorter the time lag between the sale and the cash collection. Use the following to calculate the firm's average collection period ratio:
Average collection = Days in accounting period
period ratio Receivables turnover
= 365 days
7.31
= 50.0 days
So, Sam's Appliance Shop's accounts and notes receivables are outstanding for an average of 50 days. Typically, the higher the firm's average collection period ratio, the greater the chance of bad debt losses.
One of the most useful applications of the collection period ratio is to compare it to the industry average and to the firm's credit terms. This will indicate the small company's degree of control over its credit sales and collection techniques. One rule suggests that a firm's collection period ratio should be no more than one-third greater than its credit terms. For example, if a small company's credit terms are net 45, its average collection period ratio should be no more than 60 days. A ratio greater than 60 days would indicate poor collection procedures.
Slow payer represent a great risk to many small businesses. Many entrepreneurs proudly point to rapidly rising sales only to find that they must borrow money to keep their companies going because credit customers are paying their bills in 45, 60, or even 90 days instead of 30. "This can cripple a business," warns one business consultant.
Average Payable Period. The converse of the average collection period, the average payable period, tells the average number of days it takes a company to pay its accounts payable. Like the average collection period, it is measured in days. To compute this ratio, first calculate the payables turnover ratio. Sam's payables turnover ratio is as follows:
Payables turnover = Purchases
Accounts payable
= 939,827
152,580
= 6.16 times/year
To find the average payable period, use the following computation:
Average payable period = Days in accounting period
Payable turnover
= 365 days
6.16
= 59.3 days
Sam's Appliance Shop takes an average of 59 days to pay its accounts with suppliers.
Although sound cash management calls for a business owner to deep her cash as long as possible, slowing payables too drastically can severely damage the company's credit rating. Ideally, the average payable period would match (or exceed) the time it takes to convert inventory into sales and ultimately into cash. In this case the company's vendors would be financing its inventory and its credit sales.
One of the most meaningful comparisons for this ratio is against the credit terms offered by suppliers (of an average of the credit terms offered). If the average payable ratio slips beyond vendors' credit terms, it is an indication that the company is suffering from cash shortages or a sloppy accounts payable procedure and that its credit rating is in danger. If this ratio is significantly lower than vendors' credit terms, it may be a sign that the firm is not using its cash most effectively.
Net Sales to Total Assets. The small company's net sales to total assets ratio (also called the total assets turnover ratio) is a general measure of its ability to generate sales in relation to its assets. It describes how productively the firm employs its assets to produce sales revenue., The total assets turnover ratio is calculated as follows:
Total assets turnover ratio = Net sales
Net total assets
= 1,870,841
847,655
= 2.21
The denominator of this ratio, net total assets, is the sum of all of the firm's assets (cash, inventory, land buildings, equipment, tools, everything owned) less depreciation. This ratio is meaningful only when compared with those of similar firms in the same industry category. A total assets turnover ratio below the industry average may indicate that the small firm is not generating an adequate sales volume for its asset size.
Net Sales to Working Capital. The net sales to working capital ratio measures how many dollars in sales the business makes for every dollar of working capital (working capital = current assets – current liabilities). Also called the turnover of working capital ratio, this proportion tells the owner how effectively working capita is being used to generate sales. It is calculated as follows:
Net sales to working
capital ratio = Net sales
Current assets – current liabilities
= 1,870,841
686,985 – 367,850
= 5.86
On the one hand, an excessively low net sales to working capital ratio indicates that the small firm is not employing its working capital efficiently or profitably. On the other hand, an extremely high ratio points to an inadequate level of working capital to maintain a suitable level of sales, which puts creditors in a working capital as the small business grow,. It is critical for the small firm to keep a satisfactory level of working capital to nourish its expansion, and the net sale s to working capital ratio helps define the level of working capital required t o support higher sales volume.
Profitability Ratios. Profitability ratios indicates how efficiently the small firm is being managed. They provide the owner with information about the company's bottom line—in other word, they describe how successfully the firm to conducting business.
Net Profit on Sales. The net profit on sales ratio (also called the profit margin on sales) measures the firm's profit per dollar of sales. The computed percentage show the number of cents of each sales dollar remaining after deducting all expenses and income taxes. The profit margin on sales is calculated as follows:
Net profit on sales ratio = Net profit
Net sales
= 60,629
1,870,841
= 3.24%
Most small business owners believe that a high profit margin on sales is necessary for a successful business operation, but this is a myth. Too evaluate this ratio properly, the owner must consider the firm's asset value, its inventory and receivables turnover ratios, and its total capitalization. For example the typical small supermarket earns an average net profit of only one cent on each dollar of sales, but its inventory may turn over as many as twenty times a year. If the firm's profit margin on sales is below the industry average, it may be a sign that its prices are relatively low, or that its costs are excessively high, or both.
If a company's net profit on sales ratio is excessively low, the owner should check the gross profit margin (net sales minus cost of goods sold, expressed as a percentage of net sales). Of course , a reasonable gross profit margin varies from industry to industry. For instance, a service company may have a gross profit margin of 75 percent, while a manufacturer's may be 35 percent. One business consultant advises, "A poor gross (profit) margin puts the company's profit picture in immediate jeopardy."
Net Profit to Equity. The net profit to equity ratio(or the return on net worth ratio) measures the owners' rate of return on investment. Because it reports the percentage of the owners' investment in the business that is being returned through profits annually, it is one of the most important indicators of the firm's profitability and management's efficiency. The net profit to equity ratio is computed as follows:
Net profit to equity = Net profit
Owners' equity (or net worth)
= 60,629
267,655
= 22.65%
This ratio compares profits earned during the accounting period with the amount the owner has invested in the business during that time. If this interest rte on the owners' investment is excessively low, some of this capital might be better employed elsewhere.
Interpreting Business Ratios. Ratios are useful yardsticks in measuring the small firm's performance and can point out potential problems before they develop into serous crises. But calculating the various ratios is not enough to ensure proper financial control In addition to knowing how to calculate these ratios, the owner must understand how to interpret them and apply them to the form's operation.
Sometimes business owners develop ratios that are unique to their own operations to help them achieve success. At Sports Town International, a chain of health clubs based in New York City, owner Marc Tascher has learned to watch one key ratio in particular: operating costs as a percentage of revenues. Every month Tascher tracks the performance of each club and the corporation as a whole by this ratio. Making decisions based on this calculation has helped him produce 30 percent annual growth rates in both revenues and net income. Tascher also uses this ratio as a guide for building new clubs. "I've got three main costs—marketing, space, and payroll—and I won't consider expanding into a new club unless its projected cost ratio works." He explains.
Another valuable way to utilize these ratios ins to compare them with those of similar businesses in the same industry. By comparing the company's financial statistics to industry averages, the owner is able to locate problem areas and maintain adequate financial controls. The accompanying "Gaining the Competitive Edge" feature provides an example of how entrepreneurs can use ratio analysis to identify potential problem areas in their businesses early on.
Several organizations regularly compile and publish operating statistics, including key ratios, summarizing the financial performance of many businesses across a wide range of industries. The local library should subscribe to most of these publications.
Dun & Bradstreet, Inc.
Since 1932 Dun & Bradstreet has published Key Business
Ratios, which covers twenty-two retail, thirty-two wholesale,
and seventy-one industrial business categories. Dun &
Bradstreet also publishes Cost of Doing Business, a series of
operating ratios compiled from the IRS's Statistics of
Income.
Robert Morris Associates. Established in 1914,
Robert Morris Associates publishes Annual Statement
Studies, showing ratios and other financial data for
over 350 different industrial, wholesale, and retail
categories.
Bank of America. Periodically the Bank of America
publishes many documents relating to small business
management, including the Small Business Reporter, which
details costs of doing business ratios.
Trade Associations. Virtually every type of business
is represented by a national trade association which
publishes detailed financial data compiled from its
membership. For example, the owner of a small supermarket
could contact the National Association of Retail Grocers
for assistance in gathering financial statistics relevant to
his operation.
Government Agencies. Several government agencies
(the Federal Trade Commission , Interstate Commerce
Commission, Department of Commerce, Department of
Agriculture, and Securities and Exchange Commission) offer a
great deal of financial operating data on a variety of
industries, although the categories are more general. In
addition, the IRS annually publishes Statistics of Income,
which includes income statement and balance sheet statistics
compiled from income tax returns. The IRS also publishes the Census
of Business, which gives a limited amount of ratio
information.
When comparing ratios for their individual businesses to businesses to published statistics, small business owners must remember that the comparison is made against averages. The owner must strive to achieve ratios that are at least as good as these average figures. The goal should be to manage the business so that its financial performance is above average. As the owner compares financial performance to those covered in the published statistics, he will inevitably discern differences between them. He should note those items that are substantially out of line from the industry average. However, a ratio that varies from the average does not necessarily mean that the small business is in financial jeopardy. Instead of making drastic changes in financial policy, the owner must explore why the figure are out of line. Steve Cowan, co-owner of Professional Salon Concepts, a wholesale beauty products distributor, routinely performs such as analysis on his company's financial statements. "I need to know whether the variances for expenses and revenues for a certain period are similar," he says. "If they're not, are the differences explainable? Is an expense category up just because of a decision to spend more, or were we just sloppy?"
In addition to comparing ratios to industry averages, owners should analyze their firms' financial ratios over time. By themselves these ratios are "snapshots" of the firm's finances at a single instant; but by examining these trends over time, the owner can detect gradual shifts that might otherwise go unnoticed (see fig. 1.8).
Another key component of every sound financial plan is the break–even analysis. The small firm's break-even point is the level of operation (sales dollars or production quantity) at which it neither earns a profit nor incurs a loss. At this level of activity, sales revenue equals expenses—that is, the firm "breaks even." By analyzing costs and expenses, the owner can calculate the minimum level of activity required to keep the firm in operation. These techniques can then be refined to project sales needed to generate the desired profit. Most potential lenders and investors will require the potential owner to prepare a break-even analysis to assist them in evaluating the new business's earning potential. In addition to its being a simple, useful screening device for financial institutions, break-even analysis can also serve as a planning device for the small business owner. It will occasionally show a poorly prepared entrepreneur just how unprofitable a proposed business venture is likely to be.
CALCULATING THE BREAK-EVEN POINT. The small business owner can calculate the firm's break-even point by using a simple mathematical formula. To begin the analysis, the owner must determine fixed costs and variable cost. Fixed expenses are those that do not vary with changes in sales or production volume (e.g., rent, depreciation expense, interest payments). Variable expense, on the other hand, varies directly with changes in sales or production volume (e.g., raw material costs, sales commissions).
Some expenses cannot be neatly categorized as fixed or variable because they contain elements of both. These semi variable expense change, although not proportionately, with changes in the sales or production level (electricity would be one example). These consists remain constant up to a particular production or ales volume, and then climb as that volume I exceeded. To calculate the break-even point the owner must separate these expenses into their fixed and variable components. A number of techniques can be used (which are beyond variable components. A number of techniques can be used (which are beyond the scope of this text), but a good cost accounting system can provide the desired results.
Here are the steps an entrepreneur must take to compute the break-even point using an example of a typical small business, the Magic Shop: