Effective Use Of Financial Ratios To Keep Your Eye On Your Business.
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Business owners typically have more items on their task lists than time in the day to complete them. A normal problem for most, but for business owners with a growing operation, the business of their lives can present a myriad of problems, one of the most catastrophic being fraud.
The typical evolution of a business is one where the operation eventually secures clientele or sales to keep everyone busy. Then business increases to the point where everyone is working at 100% capacity, and then additional work comes in after that, requiring additional staffing and resources to facilitate increased production. The business is now playing catch-up with it’s evolution; it’s unprepared and operating in reaction mode rather than action mode.
If not handled effectively, the business becomes an Albatross around the owner’s neck, and it takes substantial discipline to organize the facets of the business so that it becomes a smoothly run operation, ready to provide optimal customer service and a place that attracts qualified, talented staff.
Many business owners can’t reverse the ship when confronted with a business that is out of control like this. Comments like “this business owns me”, “I didn’t plan on working this hard when I started this”, or “It’s not supposed to be like this” surface, and owners without outside help and encouragement are unable to free themselves from what they perceive to be a self-made prison.
In the next series of articles, we will discuss ways to methodically transform businesses that have outgrown their small level feel and existence to larger-scale operation. All of the 4 main areas of the business: Marketing, Operations, Finance, and Administration, must undertake a formal development phase to facilitate future growth; Human Resources takes on a new meaning; gone is the mom-and-pop feel where the owner comes and goes; the reality is now formal processes to keep procedures and processes organized so that production quotas can be met.
Internal audit procedures need to be created and implemented to ensure minimization, if not complete eradication of fraud, which becomes a leading concern when businesses evolve, grow, and take on a larger operational footprint.
When the business is growing, and the owner is wearing many hats in the hope of one day getting organized, getting processes and procedures and proper staff in place, and scaling back in order to breathe, what seems to get lost in all the business is cash-flow.
The proverbial oxygen of any business, cash is at it’s most exposed in businesses at this stage in their development, and in most cases businesses at this point become sieves for the leakage of cash, since no safety nets are installed to prevent it’s illegal escape.
Cash can disappear in many ways; unethical staff can take it away outright, procedures (manufacturing or otherwise) can become sloppy due to lax or non-existent technical requirements, wastage in manufacturing businesses can slowly leech out cash via sloppy processes, and the list goes on. What is needed is disciplined, well-defined, and monitored internal audit procedures to measure, assess, and quantify operational procedures and processes to prevent fraud and facilitate the ethical and professional methods of operation that the owner always envisaged the business to abide by.
This article is the first on a series dedicated to internal audit procedures. This first one, however, deals with the owner’s high-level- 50,000 foot analysis of the business’s cash, assets and liabilities by utilizing ratios.
Financial and operational ratios are a great way to quickly assess the pulse of the business and identify areas requiring the owner’s time resources. A logical starting point for owner’s who have limited time to commit to this activity, yet understand the necessity of spending time on it, can start with the following series of ratios, identified as the PALLR sequence of ratio analysis:
This sequence of ratio analysis takes no longer than 5 minutes to complete, and along with a cursory review of the bank statement balance(s), can provide the business owner with a quick yet comprehensive high level analysis of the health of the business and easily highlight potential areas of concern that can be addressed to prevent further, more critical problems.
Notice that there are 5 areas of ratios:
- Rate of Return
Constituting the acronym PALLR, with specific ratios identified with this series of ratios listed in the “Ratio” column. The “measure” column shows the actual equation used in the ratio, and the “Standard” column lists desired metrics representing an average from 5 different service and manufacturing industries.
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Probably most commonly known, the profitability ratios measure if the business is profiting. These ratios are going to highlight whether or not the pricing of the business’s offerings are in line with the owner’s strategic goals, and whether or not and working capital problems are due to profitability concerns or from other areas.
We can see that regular monitoring of ratios provides not only an outlet to assess different performance areas of the business, but also enables the owner to eliminate those performance areas as causally related from previously identified problems within the business. For example, by seeing an operating margin in line with owner’s strategic plan, s/he can eliminate profitability as causally related to a problem with cash flow – the owner can be confident that pricing is reasonable to achieve the strategic goals of the business.
Activity ratios measure how well the assets of the business are being used, and the efficacy of the operating cycle.
The operating cycle is the sum of the manufacturing, sales, and collection cycle, and if the Receivables Turnover ratio is not in line with the standard column, then the owner knows that there is a problem lying somewhere within those 3 sub-cycles.
It’s important to measure how well assets are being used to contribute to profitability. A result below standard may mean that assets are underutilized, and that money may have been used to purchase a particular asset when it didn’t have to be. In service businesses, the main asset is staff and personnel, so the main cost to be used against sales is the total cost of employing that staff .
Some business owners are naturally averse to employing debt in order to grow. Yet, as the following chart shows, financing growth partially via debt as opposed to only by owner’s (or shareholder’s) equity can be cheaper and can enhance cash flow, due to tax advantages:
The weighted average cost of capital (WACC), identified as the pink line on the chart, actually decreases when expansion is financed by using equity AND debt. The specific percentages of debt and equity to use to optimize the WACC will vary depending on economic conditions; however, for this reason owner’s should be hesitant to use equity exclusively to finance expansion for this reason.
Too much debt, however, can hamper a business’s ability to weather unexpected economic anomalies, as will invariably occur over a business’s evolution. Debt should only be undertaken to the extent that cash flows can sufficiently cover payments and provide for a systematic paydown of principle.
If a business is profitable yet not liquid, it will soon be bankrupt. As stated before, case is the oxygen of the business, and a situation where the business is profitable yet illiquid suggests either:
-Costs greater than standard
-Pricing of products/services below optimal
Liquidity ratios show a business’s ability to pay down it’s current liabilities with current assets, such as cash and accounts receivables. A weak liquidity ratio may also expose a slow collection period, which needs to be addressed.
Rate of Return
Rate of Return ratios provide an overall “performance” guage of the business. If this ratio is askew of standard, then the business owner can drill down into the other ratios to determine when problems lie and quickly address them to get the business on track.
These are just a few ratios that exist to assess the health of your business. Reviewing them daily can prevent fraudulent activity, operational wastage or incorrect pricing models before they have a chance to do real damage to the operation.
Nicholas Kilpatrick is a partner at the accounting firm of Burgess Kilpatrick in Vancouver, B.C. He specializes in franchises, restaurants and business development, and has worked with franchise and restaurant owners to increase profitability at all stages of their businesses. He can be reached at firstname.lastname@example.org or at 604-327-9234.