FastFacts # 0270 - Financial Statement: Ratios and Benchmarks

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# 0270 -- FINANCIAL STATEMENT: RATIOS AND BENCHMARKS

Financial records, carefully maintained, provide owners and manager with the only sound measuring device for business success. They help measure the ability of a business to generate profits and to meet claims against it. They also provide the basis for isolating a business's strengths and weaknesses and may, through analysis, suggest how best to plan for profits and to maintain solvency.

With this in mind, the following ratios have been developed from year-end operating statements and balance sheets submitted by members in past Cost of Doing Business Studies. Adequate records will enable comparisons of these ratios that are valuable to the business owner/manager.

FINANCIAL INDICATORS

Current Ratio
Figure by dividing Current Assets by Current Liabilities.
This ratio compares the total of cash and the items which will be converted into cash with debts which must be paid soon. Thus, the ratio reflects ability to handle current debts. A ratio of two-to-one (@2 of Current Assets for each $1 of Current Liabilities) is considered satisfactory. When the ratio falls below two-to-one, creditors have a greater interest in Current Assets than the owner.

Debt to Equity Ratio
Figure by dividing Total Liabilities by Total Net Worth.
This ratio is a measure of the company's stability and debt position compared to the owner's stake in the business. For power equipment dealerships, this ratio should be 3.3 or less.

Receivables Turnover
Figure by dividing the total of Repair Parts and Service Sales by Accounts Receivable.
The turnover rate is meaningful when customer receivables are related to the corresponding customer sales of the business. When internal sales of parts and labor are not separated from customer sales, this ratio is not as accurate.
This ratio shows if receivables are in proportion to the amount of business transacted and may be used every month to good advantage. Divide Sales year-to-date by Receivables and compare with the ration for the same period in the past two or three years. Unfavorable trends can thus be detected.

Inventory Turnover
Cost of Sales is figured by subtracting Margin from the corresponding Sales. Figure by dividing Cost of Sales by Inventory.
This ratio shows the number of times inventory is bought and sold during the year, reflected in "Turnover" in the balance sheet. A good benchmark for this ratio is 2.5-3 times.

Inventory to Net Working Capital
Figure by dividing Inventory by Net Working Capital.
For most companies in the retail lines, inventory requirements are relatively small and supplier credit term short. However, in the power equipment industry, this ratio is extremely high because inventories are characteristically heavy and represent a major portion of Total Current Assets, and because of heavy financing of wholegoods.

Ownership Equity
Figure by dividing New Worth by Total Assets.
This ratio shows how much of the business is proprietor-owned. And, conversely, by subtracting the percentage from 100 percent, it shows how much of the business is financed by outside capital (creditors). When Net Worth is less than 50 percent of Total Assets, creditors have a greater interest in the assets than owners.

OPERATING INDICATORS

Net Working Capital Turnover
Net Working Capital is determined by subtracting Current Liabilities from Current Assets.
Rate of turnover is figured by dividing Sales by New Working Capital.
The number of times Net Working Capital turns over in a year is a good measure of activity for any business. It is a sensitive indicator of over trading or under trading. And it is a good test of how adequate Net Working Capital is for the company's scale of operation. When the ratio is too high, it is usually because the company is short of cash, and heavy on receivables and paid-for inventory. This situation promotes borrowing, or sale of inventory at a loss, to meet payroll and other fixed obligations. When it is too low, inefficient use of capital in the receivables, inventory, cash or a combination of these is in excess of the needs of the business.

Turnover of Total Assets
Figure by dividing Sales by Total Assets.
The importance of this ratio is illustrated by a company with $750,000 of Total Assets and Total Sales of $1,500,000, while another, with an equal amount of assets, achieves a Total Sales of only $1,000,000. The first is more efficient in its use of assets. However, a high rate of turnover is not necessarily the key to profits. As in the ratio Sales to Net Working Capital, high turnover may be an indicator of inadequate capital in relation to sales volume. Also, high usage of rental property by a dealer usually results in a high rate of turnover.

Return on Assets
Figure by dividing Net Profit by Total Assets.
This ratio is also an important test of operating efficiency. It is a test of management's use of the assets in the business. It lays aside all problems related to the source of funds, whether such funds are obtained from capital investment, borrowings or purchases on credit. It shows the return on total capital invested in the business (owner capital plus outside capital), which is represented by Total Assets. For power equipment dealerships, this should be about 6%.

Return on Net Worth
Figure by dividing Net Profit by Net Worth.
Using this ratio, it is important that a fair salary for the owner be included in operating expenses of the business. The owner's time is certainly worth something. Therefore, all New Profit ratios should be based upon the profit after this salary is paid. Adequacy of profit must be measured on investment returns, as well as compensate for risks. For power equipment dealerships, this should be about 20%.

Absorption Rate
Figure by dividing Parts and Service Gross Margins (and if a separate profit center, Rental Margin) by Total Fixed Operating Overhead less Variable Selling Expenses.
This ratio measures the extent to which the aftermarket sales of the company covers the expenses of the company. A higher rate allows a better competitive position for the sales department. It also helps a company better survive a downturn in the economy. The ideal situation is to achieve a 100% Absorption Rate.

PRODUCTIVITY INDICATORS

Employee Studies
Comparing your sales per employee in each category to the averages is the first step in measuring employee efficiency. The next step is to compare your current year figures to previous years.

Gross Margin per Employee
Figure by dividing department/company Gross Margin by department/total number of Employees.

Sales Productivity
Figure by dividing Sales Salaries & Commissions by Sales Department Gross Margin.
For power equipment dealerships, this ratio should be 35% or less.

Parts Productivity
Figure by dividing Parts Salaries & Commissions by Parts Department Gross Margin.
For power equipment dealerships, this ratio should be 35% or less.

-- 1996, NAEDA Cost of Doing Business Study