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Understanding financial analysis techniques

It is all very well getting up-to-date financial statements, but they don't always tell you how particular aspects of your business are doing. This needs a greater depth of analysis and interpretation. Over the years, many useful analysis techniques have been developed. Break-even analysis and ratio analysis are among the most popular.

These concepts are not easy to describe and we only provide an introduction to them. For more information look for other sources, or discuss them with your accountant. The basic information we provide should give you a general understanding of these techniques. The most important concept is break-even analysis. This determines the point at which your business begins making a profit.


Break-even analysis

Break-even analysis is particularly important in the planning stages of your business. It shows what sales and fees you need to make on a daily, weekly or monthly basis, in order to pay all your expenses.

To put together a break-even analysis, you must first separate variable costs from fixed costs. Fixed costs are predictable on a monthly basis, and occur whether or not you are open for business, while variable costs change according to your business operations, such as the cost of your supplies, material or labour.

Once you have determined these costs, you will need to work out your contribution margin. This is the difference between your income and your variable costs. This can be shown as either a percentage figure, or as a dollar amount.

Your contribution margin can be worked out according to the following formula:

(Sales - Variable Costs) ÷ Sales = Contribution Margin

For example, if your business has:

Fixed costs (FC) of $34,000
Makes sales and fees (S) of $120,000
With variable costs (VC) of $75,000.

Your contribution margin (CM) would be worked out as follows:

(S - VC) ÷ S = CM

($120,000 - $75,000) ÷ $120,000 = 37.5%

Therefore, your contribution margin is 37.5% of sales, or $45,000. All your fixed costs must be paid for out of this 37.5% contribution margin.

To find out your break-even point (BE) you use the following formula and the percentage contribution margin figure:

Fixed Costs ÷ Contribution Margin = Break-Even Point

Using the same example, therefore your break-even point is worked out as follows:

FC ÷ CM = BE
$34,000 ÷ 37.5% = $90,666.

If you are happier using the dollar amount the formula becomes:

Fixed Costs ÷ Contribution Margin x Sales = Break-Even Point

FC ÷ CM x S = BE
$34,000 ÷ $45,000 x $120,000 = $90,666.

In other words, you must make sales and fees of approximately $91,000 before all your fixed and variable costs are met and your business is breaking-even and starting to make a profit.

Taking this a step further, it is also useful to know what your margin of safety is. This is the amount your total sales and fees can drop by before your business starts making a loss.

The margin of safety (MS) formula is:

(Sales - Break-Even Point) ÷ Sales = Margin of Safety

(S - BE) ÷ S = MS

Therefore:

($120,000 - $90,666) ÷ $120,000 = 24.4%

A high percentage figure is preferable as it indicates your business is achieving good sales/fees and incurring manageable levels of fixed and variable costs.


Ratio Analysis

Ratio analysis was developed to determine the stability of various financial aspects of a business. It shows the relationship between two figures, or two aspects of your business. It helps you work out your business' financial weaknesses and strengths, so that you can take appropriate action.

Ratio analysis also offers a view of your business' competitive performance in relation to similar businesses in your industry. We will only discuss a few ratios here, as some can become very complicated. Essentially, we will group the ratios we discuss into the following types:

• Measures of liquidity
• Profitability ratios
• Efficiency ratios.


Measues of liquidity

These ratios analyse the available liquid assets your business has at any given time to meet current liabilities. In other words, it tells you how much cash-on-hand you have, as well as assets that can readily be turned into cash. This lets you know how much money is accessible if needed to pay your liabilities or debts.

A good rule of thumb is the greater your liquidity, the better. However, bear in mind, the higher the liquidity ratio, the greater the proportion of resources tied up in relatively non-productive assets.

This may have an adverse effect on earnings. It is necessary, therefore, to aim to achieve a balance between earnings and liquidity.


Current ratio

This is the difference between current assets and current liabilities. The current ratio (CR) is calculated by dividing current assets (CA) by the current liabilities (CL) listed on your balance sheet:

Current Assets ÷ Current Liabilities = Current Ratio

Say your current assets are $34,000
Your liabilities are $18,000

Your current ratio would therefore be:

CA ÷ CL = CR

$34,000 ÷ $18,000 = 1.9%
Therefore your current ratio = 1.9 : 1

This means for every dollar you owe you have $1.90 available in current assets. A current ratio of assets to liabilities of 2:1 is usually considered to be acceptable (ie., your assets are twice your liabilities).


Fixed assets ratio

Fixed and current assets "compete", if you like, for the limited funds available to your business. Therefore, you need to reach a balance. The best depends on your type of business. You may, for instance, have most of your capital tied up in fixed assets, like equipment, with minimal investment in current assets such as stock.

Every type of business has different assets investment requirements and you may want to compare, or benchmark, your level of investment with others in your industry. The fixed asset ratio is calculated by comparing the proportion of a business' total fixed assets against total assets, as follows:

(Fixed Assets ÷ Total Assets) x 100 = Fixed Asset Ratio

For example, taking your $34,000 current assets (CA)
With fixed assets (FA) of $83,540
Your total assets (TA) are $117,540.

Therefore, applying the ratio:

(FA ÷ TA) x 100 = FA ratio

($83,540 ÷ $117,540) x 100 = 71%.
Your fixed asset ratio is 71.4:1.

This can, of course, affect your profitability. If your fixed assets are too high, you may have "over-capitalised" your business (you have too much money tied up in fixed assets – property, for example). You may need to "off-load" some of your excess capital. If your figure is too low, it suggests that you may need to invest some money in your business.

Fixed asset holdings generally equate to capacity and increasing your capacity may also increase your profitability. For example, a pizza take-away shop may find that buying an extra oven can improve productivity (output) dramatically.


Profitability measures

Making money is what being in business is all about and various profitability ratios will help show how successful your business is.

These relate your profit level to your sales and fees and show to what extent each dollar of sales/fees generates profit for your business.

Moreover, they relate profit to your assets and show how productive your assets are in generating profit. These ratios include the gross profit margin and the net profit margin.


Using you profit margins

The gross profit margin (GPM) calculates the average profit per dollar of sales/fees before operating expenses. The ratio is defined as:

Gross Profit ÷ Sales = Gross Profit Margin

For example, if, according to your balance sheet your gross profit (GP) was ,000
Total sales/fees (S) were $105,000

GP ÷ S = GPM

$31,000 ÷ $105,000 = 29.5%

The gross profit percentage is 29.5%. The "ideal" percentage can vary dramatically between industries, so you might want to benchmark your performance against others in your industry. If you find that your gross profit margin is low, it is likely your income is below expectations or your direct costs are too high, and you may need to think of strategies to boost your sales and fees or reduce costs.

You can also use the gross profit margin to assess how much you can increase your prices without it affecting your profitability. This is an interesting concept for many businesses, particularly if you are considering discounting in order to obtain market share.

Many business owners worry that increasing their prices will result in a loss of income, but fail to realise that they then need to sell less to achieve the same income. For instance, you only need one $100,000 sale or fee to have a great month but you will need hundreds of $1000 sales/fees to get the same return.

There is a trade-off between price and volume. Higher prices usually equate to less volume, but not necessarily less profitability. The aim is to improve your gross profit margin, as the higher your gross profit margin, the better off you are. If your present margin is 40% and you increase your prices by 10%, you can have a 20% decline in revenue and still have the same gross profit. This is particularly useful for retail businesses, as they have many factors, such as price, that can be varied.

An added benefit of increasing prices is that it may reduce the number of "time wasting" customers. These customers often cost you more than they are worth and take up valuable time and resources. With the "time wasters" gone, you can concentrate on your "A-grade" customers, who will likely not be put off by the price increase.

The following table will give you an idea of how much you can increase your prices before your gross profit is reduced.

If your Gross Profit Margin is:

20%

25%

30%

35%

40%

45%

50%

Increase your price by:

Your revenue could decline by the amount shown below before your gross profit is reduced

2%

9%

7%

6%

5%

5%

4%

4%

4%

17%

14%

12%

10%

9%

8%

7%

6%

23%

19%

17%

15%

13%

12%

11%

8%

29%

24%

21%

19%

17%

15%

15%

10%

33%

29%

25%

22%

20%

18%

17%

12%

38%

32%

29%

26%

23%

21%

19%

14%

41%

36%

32%

29%

26%

24%

22%

16%

44%

39%

35%

31%

29%

26%

24%

18%

47%

42%

38%

34%

31%

29%

26%

20%

50%

44%

40%

36%

33%

31%

29%

25%

56%

50%

45%

42%

38%

36%

33%

30%

60%

55%

50%

46%

43%

40%

38%

Remember, providing something "cheaply" is not always the best tactic. Consumers are often willing to pay more for quality goods and services. If you feel this is appropriate to your business, start by testing certain items. Ultimately, the "market" will determine the value and price of your product.


Return on assets

The return you receive on your business assets may be measured by two interdependent factors - net profit margin and asset turnover. Net profit is calculated by:

Gross Profit - Total Overheads ÷ Total Income x 100 = Net Profit

It is advisable to calculate both figures as a higher net profit will normally reflect a more efficient or profitable operation. A higher asset turnover indicates you are earning more revenue from each dollar of assets. This will then put your return on assets figure in better context. Return on assets will give you an indication of how well your business is performing for the amount of money you have invested.

Net Profit Before Tax ÷ Total Assets = Return On Assets

For example, if net profit is $48,750
Total assets are $310,135

$48,750 ÷ $310,135 = 15.6%
Therefore your return on assets is 15.6%

Return on assets is useful as it allows you to gauge what sort of return you are getting as a result of all your hard work. A figure in excess of 10% is considered good. The net profit margin measures the efficiency with which you are using your assets to generate sales and fees. Both the net profit margin and the asset turnover are important, but it is their combined effect on the return on assets that matters most to a business.

If you are operating a business with a high net profit margin, you can afford to have a lower rate of asset turnover because you are achieving a good return on assets. The high profit margin provides a "buffer" for the lower sales or fees volume. Your business is also less sensitive to variations in the net profit margin because it is turning its assets over less frequently. These facts should mean you have a secure business.

If your profit margin is too low you may want to consider the some of the following:

• Increase your prices (but consider the volume impact)
• Decrease your costs by more efficient stock purchases (consider "just-in-time" purchases, settlement or volume discounts, rebates)
• Decrease operating expenses through leaner operations (avoid unnecessary expenditure on entertainment, marketing, overheads).

Alternatively, you can try and improve your return on assets by increasing the asset turnover in the following ways:
• Reduce current assets (such as stock levels)
• Reduce fixed assets, such as size of building or level of equipment.

Choose the strategies which will produce the most effective results for you, given your particular set of circumstances. For service/retailers, this is typically staff costs, stock or excess floor space. Sometimes these can be tough decisions, but could mean the survival of your business.


Efficiency Ratios

If your assets are being used to their best, you would expect that the return on your assets should also be at a maximum.

One way of assessing this is to measure their frequency of turnover, such as asset turnover. You can measure this with the following ratios and use them to track improvements.


Asset turnover

This ratio can be calculated as follows:

Sales ÷ Total Assets = Asset Turnover

For example, if sales/fees were $120,000
Total assets $50,000
$120,000 ÷ $50,000 = 2.4 times

Therefore your asset turnover is 2.4. Obviously, the higher the turnover, the better use of your assets.


Average collection period

This ratio calculates how long it takes for you to collect your money from your creditors. This is useful for businesses whose customers may be on 14 or 30 day credit terms. The average collection period is used to compare the average age of debtors (ie. how long have they been outstanding) from one point in time to another and shows how good your clients are at paying their bills.

It’s an "overall" picture, so it does not tell us anything about individual accounts. To do this it is necessary to age them separately. Most accounting software products are able to perform this function.

(Debtors ÷ Total Credit Sales) x 365 days = Average Collection Period

If debtors = $6,640
Total credit sales/fees = $34,460
($6,640 ÷ $34,460) x 365 = 70 days

Therefore your average collection period is 70 days. Generally it is preferable to keep this to below 60 days.

If the average collection period is high or growing, it is a definite signal that you will need to take action to collect your debtors quicker. By not paying your invoice on time, your customers are using your funds for their own purposes. That's why they are "good" customers!

If the average collection period is low, you might consider extending more credit in an effort to stimulate greater sales/fees. Some customers rely on credit, so a "tight" credit policy can sometimes hurt your business. However, it is obviously far better to have a short collection period.


Notes on using ratios

Don't make the assumption that ratio analysis will tell you everything you need to know about your business' financial performance however. Ratios provide a great deal of information, but they do have limitations.

Remember that ratios only indicate the relationship between two sets of figures. What is more, one ratio should not be taken to represent the whole of your business. Try to get an overall picture.

Ratio analysis allows you to compare current and past performances of the company but doesn't offer any indication of future performance.

Ratios are developed for specific periods. Consequently, if you operate a seasonal business, ratios may not provide an accurate measure of financial performance.

Additionally, if you make comparisons with other businesses in your industry, keep in mind not all businesses are the same. Ratios are usually comparisons with industry averages, however your business will not, and should not be, exactly the same as others in your industry.

It should also be noted that financial statements are often prepared by different methods, resulting in financial ratios that may not present an accurate account of the average business in your industry.


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