Ratio Analysis

So let’s talk about the heart of the KZ Management approach to helping you with your business –

 

Ratio Analysis

What is Ratio Analysis you ask? A very good question, and one that I will answer in a minute. First, I want to tell you a story. Way back when I was an Officer in the United States Marine Corps, one of the things that I had to know was how to administer emergency first aid on the battlefield. There were three things that I was taught to do if one of my men sustained an injury.

 

First – stop the bleeding.

Second – start the breathing

Third – treat for shock

 

So what does that have to do with Ratio analysis? OK…well…if cash flow is the life blood of your business and you’re bleeding cash, then you need to stop that before anything else. After you stop bleeding cash, then you need to start the business breathing again…that is start marketing and getting sales…and finally treat for shock. That is…solidify the changes needed in the business to make sure the first two steps stay in place.

 

So if we do all that, don’t we need a way to monitor the life signs of the patient…in this case your business? That’s what Ratio Analysis is for. Ratios are the life signs of your business (just like pulse, temperature and respiration) and their analysis on a month to month basis is the basic building block and starting point for everything that KZ Management does. If you do nothing else for your business, let us teach you how this ratio analysis can be used to get you on the right track and keep you there.

Ratio Analysis is a way to look at a business in the way that investors may look at your business. They are measures of your business’s health…it’s ability to pay its debts, invest in growing sales and create profits. There are a lot of ratios out there that you can look at, but we have chosen the following ones as being the most meaningful to small business.

 

Some of these are obvious like profit margin, some like the z score are a little more obscure but no less vital to know. So let’s go through them and see what they tell us.

 

Current and Quick ratios are both measures of liquidity meaning how easily can a business pay its debts. These are measures of a company’s available assets vs. liability’s. The current ratio measures liquidity with inventory included (really good if your inventory moves quickly) and the quick ratio calculates it without inventory (good if inventory doesn’t turn as quickly). So both these ratios measure how easily your company can handle its debts, or in other words, how easy is it to pay the bills. That may be good to know. So what’s a good number for these ratios to be? That depends on your business. Depending on how quickly you can turn inventory a ratio of 1 and above is best, meaning that for every one dollar of long and short term debt your company has, you have one dollar of assets to cover it. More then a 1 is better, less is a problem.

 

Net Working Capital and the Net Working Capital Ratio are measures of what money you have to work with to grow your business. It is the money left over after you cover all your debts. Again, the higher this ratio, the better. So let’s say your company has a Net Working Capital Ratio of .5 . This simply means that you have fifty cents out of every dollar of assets to use to help you grow your business.

 

Return on Assets – This is essentially a measure of how successful you are in growing your business. You invest your working capital in inventory and the operating expenses of your business and this ratio measures how much money you make on that internal investment. Like most investments, the more you can get out of every dollar invested, the better.

 

Profit Margin – This is the one that is probably most familiar to the most people. Expressed as a percentage of net sales, it is a measure of what is left over from every dollar of sales after you have covered the cost of the things you sold and paid all of the other expenses of the business over a specific period of time. The interesting thing about this ratio is that unlike some of the other ones, this one is subject to the most manipulation. It is completely possible for a smart business operator to run a wildly successful business and show little or no net profit. Of course, a negative net profit margin is bad. Let’s just say that you always want a positive net profit margin.

 

Inventory Turnover – This one measures how fast the dollars you invest in inventory come back to you followed by some their friends (keep in mind that is the whole point – spend some money so that you can make some money). The faster inventory turns at a profit, the faster you make money. Simple as that. By the way – This one also determines if you should be looking at the current or quick ratio as a measure of how easily you can meet your debt obligations.

 

Net income return on working capital – Expressed as a ratio this gives an indication of how much net profit you are getting out of the money invested in growing the business.

 

Z-Score – OK…this may be the most obscure ratio, but it is by far the most interesting. It is a weighted compilation of all the above that was invented originally to measure the financial health of a business for investment purposes. It actually is a predictor of how close a business may be to financial insolvency (going broke, going out of business, bankruptcy…call it what you will). On a scale of 0 – 3 plus, if your business has a score of less then 1.8, you need a radical course correction or you are toast in less then six months. 1.8 to 2.7, you are in serious danger and unless you get some help immediately things are invariably going to get worse. 2.7 to 3 is a warning that you need to take stock of what’s going on in your business and make changes to get things back on track. A 3 and above indicates that things are going great and you need to do more of everything you are doing so you can continue to make money and grow your business successfully.

 

So let me ask you a question…How you doing? These ratios tell you, but only if you know how to use and monitor them on a monthly basis. If you don’t, or if you need help understanding how you can use this kind of analysis to make your business better, give us a call and let us explain how our low cost approach to helping you be successful can pay off in big dividends.

 

And for those of you who have read this far and want some more, my next installment in this series will take a look at a real company and how over a five year period these ratios and their analysis both predicted the eventual downfall of the company and, if they had been paid attention to by ownership, could have saved the company.

 

If you’d like to learn how KZ Management can leverage ratio analysis to help your business, contact us today.

Until next time….

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