FW20-USING FINANCIAL ANALYSIS

YOUR POSITION

Look at the map

MAP

195 days before opening.

1. Balance sheet and income statement 2. Liquidity ratios 3. Solvency ratios 4. Profitability ratios 5. Return on equity 6. Do it yourself 7. Coaching

INTRODUCTION

When starting your biz, you have to ask yourself the following questions:

-Can my business pay its bills?

-How is my business financed?

-Is this business profitable?

To answer these questions, you have to deal with some ratios and their knowledge is the main objective of the financial analysis.

Amongst these ratios, the Du Pont Chart is the most useful. It's just like your Global Positioning System!

Duration

Lesson: 1,5 hours

External readings and quiz: 3,5 hours

Do it yourself: 2 hours

Total: 7 hours

Objectives:

The objectives of the course are:

-To describe the main ratios and to explain their meaning.

-To underline some practical rules that you must keep in mind regarding a new business.

1. Balance sheet and income statement 2. Liquidity ratios 3. Solvency ratios 4. Profitability ratios 5. Return on equity 6. Do it yourself 7. Coaching

1-BALANCE SHEET AND INCOME STATEMENT

A ratio is a division with a number on the top (numerator) divided by a number on the bottom (denominator). These numbers are values taken from the balance sheet and the income statement. So we have first to reproduce here the figures that we have used in the previous module:

11-Balance sheet

---------------------------12/31/2000---------12/31/2001

ASSETS:

Cash--------------------------14000------------------ 14000

Marketable securities---------------0--------------------2000

Account receivable--------------5000------------------- 3000

Inventories--------------------- 5000------------------ 10000

TOTAL CURRENT ASSETS-------24000-----------------29000

Property and equipment-----------3000-------------------6000

Less depreciation---------------------0-------------------1000

Net property and equipment-------3000--------------------5000

land and intangible-------------------0--------------------6000

TOTAL ASSETS------------------27000-----------------40000

LIABILITIES:

Account payable-------------------3000-------------------9000

Note payable--------------------------0-------------------6000

Current portion of long term debt-------0-------------------2000

TOTAL CURRENT LIABILITIES------3000-----------------17000

Long term debt---------------------7000-------------------5000

TOTAL LIABILITIES---------------10000-----------------22000

OWNER EQUITY-------------------17000----------------18000

TOTAL LIABILITIES AND EQUITY--27000-----------------40000

12-Income statement

-------------------------------12/31/2000------12/31/2001

Sales to customers-----------------10000-------------15000

Cost of goods sold-------------------3000-------------6000

GROSS INCOME---------------------7000-------------9000

General and adminis. expenses------------0-------------5000

depreciation-----------------------------0-------------1000

OPERATING INCOME-----------------7000------------3000

income taxes-----------------------------0------------2000

NET INCOME. ------------------------7000------------1000

With these two financial statements, it is quite easy to follow and to understand the calculation of each ratio.

We have calculated seventeen ratios from the balance sheet and the income statement. For each ratio, the first line gives the formula and the second line gives the calculation with the figures coming from above.

1. Balance sheet and income statement 2. Liquidity ratios 3. Solvency ratios 4. Profitability ratios 5. Return on equity 6. Do it yourself 7. Coaching

2-LIQUIDITY RATIO

Liquidity ratios answer to the question: How can my business pay its bills. In fact it's quite the most important challenge every new biz has to met.

Definition: The liquidity ratios measure the company’s ability to enter cash and to pay its bills

An asset is liquid if it can be converted into cash. A liability is liquid if it must be repaid in the near future. There are two ratios to measure the liquidity of a company’s assets relative to its liabilities: the current ratio and the acid test.

A current ratio of 2 or better is considered as good.

The current ratio is also called working capital ratio. Working capital measures the ability to pay current obligations.

Working capital should be positive.

Down earth advice

When establishing your projected balance sheet for your business plan, you must always set up a positive working capital. A negative working capital (or close to zero) is a non starter for any biz angels, banker or financial analyst. Even if your project is profitable, these people will not consider it any more.

Keep in mind this fundamental rule: The working capital must be positive.

Inventory must be sold quickly.

A simple way to calculate average inventory is to add the beginning and ending inventory balances (12/31/2000 and 12/31/2001), then to divide them by two.

As with receivables, it can be useful to convert inventory turnover into days. This ratio is called day's sales on hand.

This means that the company has an average of 182 days’ worth of sales in inventory. This number can only be judged good or bad compared to other business norms: For example, a business selling toys will have a big number of days because the sales mainly occur at christmas.

Down earth advice

I do not like too much inventories. The best rule is the following: When a product is ready to be sold, it must be immediately sold. Inventories of raw materials and parts can often be justified but a large figure of finished products often means that the selling process suffers from some weaknesses.

As it has been said above, this situation is often due to seasonal activities. For this reason, when thinking about your future business, try to avoid those which depend on seasonal activities.

1. Balance sheet and income statement 2. Liquidity ratios 3. Solvency ratios 4. Profitability ratios 5. Return on equity 6. Do it yourself 7. Coaching

3-SOLVENCY RATIO

Definition: Solvency ratios measure the relationship between debts and owners equity and examine the proportion of debt the company is using.

31-Debt to equity ratio

The debt to equity ratio measures the extent to which the owners are using debt rather than their own funds to finance the company.

A debt to equity of 1 or less is often good. In another way, an important debt offers a good leverage as long as the company can handle its interests and principal payments.

To evaluate the financial leverage, another ratio adds the owner 's equity to the liabilities in the numerator. In this case, it will give: 22000 + 18000 / 18000 = 2,2

Real life example:

Do not dream too much. A new business must mainly rely on its equity because it will not easily find money to borrow. What is more, remember that the leverage is only good as long the profit yields are superior to the interests paid!

Along my career, I have met many leveraged companies because they are currently spending a lot of time with their bankers to negotiate low interests or to borrow more money! Most of the time, these companies, one day or one another, fell in troubles.

In the long run, I have observed that the companies relying on their own equity were doing pretty well and established a strong legacy.

32-Debt ratio

The debt ratio relates long term debt to all financial resources (liabilities and equity).

Of course among the liabilities, it's better to have a big portion of long term debt than a large amount of short term obligations!

1. Balance sheet and income statement 2. Liquidity ratios 3. Solvency ratios 4. Profitability ratios 5. Return on equity 6. Do it yourself 7. Coaching

4-PROFITABILITY RATIO

Definition: The profitability ratios measure the profit a company makes in relation to assets and sales.

41-Break even point

Before introducing the profitability ratios, it's worth to recall you some formula that we have already learnt regarding fixed costs, variable costs and break even point.

Fixed costs remain the same regardless of the amount of sales. For instance, assurance and rental costs are fixed costs.

Variable costs change with the volume of sales. For instance, raw materials, delivery costs and labor forces involved in the production are variable costs.

Total costs are a combination of these two. The formula is the following:

Total costs = fixed costs + (variable costs per unit x unit sold)

Of course, fixed costs must be kept down as much as possible. If sales decrease you can make cuts in your variable costs. If you are stuck with high fixed costs, your business can go to bankruptcy

Break even point: The break even point is when fixed costs are recovered from sales but no profit is made.

As an example, you have 5 000 $ in fixed costs regardless the amount of sales. The selling price is 15 $ per bottle, the variable cost per bottle is 10 $.

The break even is then:

This means that you must sell 1 000 bottles to recover your fixed costs. With 800 bottles you go in red. With 1 100 bottles you begin to make profit. You can also raise your selling prices.

The same equation can be used to calculate a target volume to yield a wanted global profit:

If you yield a profit of 10 000 $, the target volume is:

Then the following question is to be answered: Is my target volume reasonable in relation to my market? This question is crucial because a new biz must have a significant gross margin.

42-Gross margin

Gross margin relates gross income to sales.

It is said that the higher the gross margin, the better. We have already underlined that gross income close to zero was a non starter for a new biz.

43-Operating margin

Operating margin relates operating income to sales:

It is interesting to compare the operating margin to the gross margin.

In our example, we have a gross margin of 60 % and an operating margin of 20 %.

It means that the management in some areas (general and administrative expenses) is bad. The administrative staff is certainly too important. You have to reduce rapidly a lot of costs.

44-Net margin

Net margin measures net income related to sales:

The net margins can only be evaluated by comparing this ratio within years in your biz or with those of similar companies.

45-Asset turnover

The asset turnover ratio measures the management’s ability in using assets to generate sales:

Some people think that having a lot of assets is a good thing for a company; the more the better. This idea is wrong. A company’s value is in its income stream, and its assets are simply a means to achieve this goal. The ideal company would produce income without assets!

46-Return on assets

Return on assets (ROA) shows the management’s capability to generate profit on using assets:

A decrease in return on assets may mean that assets grow faster than sales. It's not a good trend.

1. Balance sheet and income statement 2. Liquidity ratios 3. Solvency ratios 4. Profitability ratios 5. Return on equity 6. Do it yourself 7. Coaching

5-RETURN ON EQUITY (ROE)

This is the King amongst ratios.

Definition: Return on equity (ROE) measures the return on owners’ investment in the company:

51-Return on equity and price earning ratio.

The return on equity is given by the following formula:

In calculating this ratio, it can be worth to exclude the extraordinary items which are meaningless.

In the same way, be aware that a new business should show lesser rates of return than a old business with older assets.

Anyway, the above ratio is weak: The 500 american's largest corporations shows an aggregate ROE of 14,6%.

Down earth advice:

You do not enter in business for having fun! You must target a ROE equal or superior to 20%. Below this figure, you will never get any help from the business community ( biz angels, bankers and so on)

External readings

Go to: www.bizstats.com . You will find here a lot of data base and notably the ROE in different industrial branches. What is more, you will get some figures about the earning of small business.

The ROE is also called Price Earning ratio in stock exchange.

A person who buys one share must wait 18 years to recover the cost of his share (2 000) with the income per share (111) generated each year by the company. In fact a stock price of a share is different from its book value.

52-The Du Pont Chart

The Du Pont Company has created a financial analysis chart based on relationships between different ratios. I think that this chart is the best available financial tool and I recommend you to learn it by heart.

The Du Pont chart is the following:

It shows that management has only three levers for controlling ROE:

Any decision regarding the prices or the sale volume, the assets and the ratio debt to equity has an impact on the ROE.

This chart must be considered as your Global Positioning System!

External readings and quiz:

Go to: www.investopedia.com . Click on "Tutorials" and then on "Ratio analysis". You will find here 19 ratios: A good revision and complementary comments.

1. Balance sheet and income statement 2. Liquidity ratios 3. Solvency ratios 4. Profitability ratios 5. Return on equity 6. Do it yourself 7. Coaching

Lesson summary :

The ratios are made up with figures coming from the balance sheet and the income statement.

There are four major categories: Liquidity ratios, Solvency ratios, Profitability ratios and Return on Equity (ROE).

Ratios are often used within the years to see the evolution of the company. They are also used by comparison with the ratios of similar biz. Regarding a new biz, these ratios provides with some general rules that you have to follow:

-Have a positive working capital.

-Have a sufficient gross margin.

-Have an operating margin not too much lower than the gross margin.

-Have a high positive return on equity ( 20% and more)

Amongst the ratios, you must always scrutinize the current ratio (day to day management) and the Du Pont chart which enables you to pilot your business and to improve your Return on Equity.

1. Balance sheet and income statement 2. Liquidity ratios 3. Solvency ratios 4. Profitability ratios 5. Return on equity 6. Do it yourself 7. Coaching

DO IT YOURSELF

Take your documents established in FW19 and calculate all the ratio in accordance with the lesson.

1. Balance sheet and income statement 2. Liquidity ratios 3. Solvency ratios 4. Profitability ratios 5. Return on equity 6. Do it yourself 7. Coaching

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