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Reading Your Financial Instrument Panel

November 22, 2009

Whether your business is big or small, whether you are an investor, owner or manager, you will soon be looking at year end financial statements. You may know the business inside and out, but the annual financial statement can often look as complicated as the instrument panel of a jet airplane.

Assume for a moment that your business is an airplane and that you are the pilot. Your financial statements are the instruments in your cockpit. They provide a wide range of key information that is essential to the safe piloting of your craft. Typically, if the bottom line of the business is acceptable, there isn’t much study of this seemingly complex data.

The reading of the instrument panel of your business is not as complicated as it might seem. Few figures in a financial report are highly significant by themselves. It is their relationship to other figures and other time periods that is important. Financial analysis is largely a matter of establishing those significant relationships and monitoring the trends.

Three widely used analytical techniques are 1) dollar and percentage changes, 2) component percentages and 3) ratio analysis. Using these methods, a quick glance at the financials give you a indication of progress or will flash warning signals if there are impending difficulties.

Reading a financial statement without applying these techniques and having standards of comparison is a waste of time. The past performance of your company and the performance of similar companies are two commonly used standards. Begin to build a historical base on your company and search out industry information from such sources as the library, trade associations, government reports and published financials.

When analyzing dollar and percentage changes, the dollar amount of any change is the difference between the amount for a base year and a comparison year. The dollar amount of change from year to year is of some interest, but reducing this to percentage terms adds an important perspective. The percentage change is computed by dividing the amount of change between the years by the amount for the base year. This will yield an analysis that will indicate if the changes in your business are uniform or if there is need for management attention in selected areas.

The percentage relationship between any particular financial item and a significant total that includes this item is a component percentage. When reviewing component percentages, you will begin to see the relative impact of various parts of your business.

One application of component percentages is to express each asset group on the balance sheet as a percent of total assets. For example, divide inventory by total assets and fixed assets by total asset value to determine their relative importance. Another application is to express all items on an income statement as a percent of net sales.

Ratio analysis is a commonly used method of comparison. It simply means to express mathematically the relationship between two significant numbers. The following are several frequently used ratios.

Current Assets to Current Liabilities. Current assets, those assets that are listed in the top section of your balance sheet and which are expected to be converted to cash within a twelve month period, are divided by current liabilities, those liabilities that are falling due within one year. This ratio is one of the most common and is referred to as the current ratio. While there are many exceptions, it is generally assumed that a healthy current ratio is two to one. Selected industry averages are as follows; general retail, 3.15 to 1; grocery wholesalers, 1.83 to 1; electronic component manufacturers, 2.56 to 1.

Net Profits on Net Sales. Take your net earnings after all taxes and divide by total net sales. Retailers in the building products area average 2.93%; wholesalers of industrial machinery average 2.64%; producers of pharmaceuticals average 6.73%.

Net Profit on Tangible Net Worth. Tangible net worth is the total equity of the stockholders and it is computed by subtracting total liabilities from total assets. Divide net profits by tangible net worth. This ratio is looked at as one of the most important indicators of profitability. A 10% return is regarded as a minimal acceptable return.

Net sales to inventory. Divide annual net sales by the inventory as carried on the balance sheet to obtain a measure of inventory turnover. Strict accounting requires computation of turnover by comparing annual cost of goods sold with average inventory. However this specific information is sometimes not readily available for easy comparison. Retailers average turnover is 5 to 1, wholesalers do somewhat better and inventory turns in manufacturing are lower.

Total debt to Tangible Net Worth. Divide total current debt and long term debt by tangible net worth. This will yield an indication of the businesses ability to support the debt load. When this relationship exceeds 100%, the equity of the creditors exceeds that of the owners.

As you sit down to review this year’s financial reports, apply these basic analytical tools to make meaningful the complex data in the instrument panel. Because it’s your business, keep it flying straight and level.

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