Ratio analysis can be an effective and useful management tool if ratios are calculated on items that are meaningful and where practical steps can be taken to make improvements in business operations based on the information the ratios reveal.
Dynamic analysis and comparisons over time, that show trends and evolutions, can be particularly useful in tracking, monitoring and controlling those items that are key to the success of the business.
Benchmarking, comparisons with competitors, and ratio analysis that shows your position in your specific market segment can make you aware of developments and areas of opportunity that can make your business more competitive, and ultimately more profitable.
Saturday 1 January 2011
Ratios-10
If you use a baseline period expressed in terms of 1.00, the percentage increase or decrease in sales, gross margin, net income, or any other income statement line item will be evident from the comparative analysis.
Other ratios that may be useful could be based on other types of data. For example, in a labor-intensive environment where the output of each individual employee is a key factor in sales and profitability, useful ratios could include:
Sales by Employee = Total Sales / Number of Employees
Added Value by Employee = Total Added Value (Gross or Net Profit) / Number of Employees
In a capital-intensive environment, ratios related to the investment in equipment, or maintenance costs may be more relevant:
Expense Analysis Ratios
One type of ratios that can be used to track expenses is by comparing different categories of expenses to sales:
Fixed Expenses or Overhead / Sales
Variable Expenses / Sales
Personnel-related Expenses / Sales
This type of ratios will be useful to the extent there are parameters established, comparison is made using benchmark data, or the evolution of expenses is compared from one period to another.
Another way to analyze expenses is by comparison to an associated criteria, such as number of employees, customers, or products. These ratios give a type of unit cost which, when compared to a parameter, or when followed over time, can provide indications of where variances are occurring:
Customer Service Expenses / Number of Customers
Advertising Expenses / Number of Products
Production Expenses / Number of Units Produced
Personnel-related Expenses / Average Number of Employees
Productivity Ratios
Productivity rations are intended to show the results obtained with the expenses incurred or the resources employed. Some overall ratios include:
Net Income / Expenses
Sales / Expenses
Production / Expenses
Trade Accounts Receivable / Expenses
More specific ratios can be calculated using virtually any type of criteria. Ratios that are meaningful will depend on the nature of the business; that is, what factors affect productivity and can be tracked and controlled.
Another productivity ratio, that is probably more oriented toward a manufacturing or production environment, is:
Utilization of Productive Capacity = Production Obtained / Production Capacity
Ratios of Effectiveness
Effectiveness has to do with comparing actual results with budgeted, forecast, or expected results. These ratios can be calculated on any item for which actual and expected results are available, and which are of interest in managing the business. Some examples include:
Forecast Profit / Actual Profit
Forecast Sales / Actual Sales
Forecast Production / Actual Production
Forecast Trade Receivables / Actual Trade Receivables
It should be noted that calculating the ratios as indicated above will yield a ratio greater than 1.0 if actual results are lower than forecast results. If you want to see a ratio of less than 1.0 if actual results are lower (for example, you want to see what percentage of forecast or budgeted profit you actually achieved) you would have to invert the ratios.
To see how efficiently you controlled expenses, you could calculate efficiency ratios of any individual expense item, or any grouping or total expenses:
Efficiency = Forecast Expenses / Actual Expenses
In addition to effectiveness and efficiency, quality control is another concern that can be expressed through ratio analysis:
Number of Customer Complaints / Number of Customers
Number of Late Deliveries / Total Orders Delivered
Quality Evaluation and Assurance Costs / Sales
Costs of Damages and Defects (Sales Returns) / Sales
Cost of Service After the Sale / Sales
Other ratios that may be useful could be based on other types of data. For example, in a labor-intensive environment where the output of each individual employee is a key factor in sales and profitability, useful ratios could include:
Sales by Employee = Total Sales / Number of Employees
Added Value by Employee = Total Added Value (Gross or Net Profit) / Number of Employees
In a capital-intensive environment, ratios related to the investment in equipment, or maintenance costs may be more relevant:
Expense Analysis Ratios
One type of ratios that can be used to track expenses is by comparing different categories of expenses to sales:
Fixed Expenses or Overhead / Sales
Variable Expenses / Sales
Personnel-related Expenses / Sales
This type of ratios will be useful to the extent there are parameters established, comparison is made using benchmark data, or the evolution of expenses is compared from one period to another.
Another way to analyze expenses is by comparison to an associated criteria, such as number of employees, customers, or products. These ratios give a type of unit cost which, when compared to a parameter, or when followed over time, can provide indications of where variances are occurring:
Customer Service Expenses / Number of Customers
Advertising Expenses / Number of Products
Production Expenses / Number of Units Produced
Personnel-related Expenses / Average Number of Employees
Productivity Ratios
Productivity rations are intended to show the results obtained with the expenses incurred or the resources employed. Some overall ratios include:
Net Income / Expenses
Sales / Expenses
Production / Expenses
Trade Accounts Receivable / Expenses
More specific ratios can be calculated using virtually any type of criteria. Ratios that are meaningful will depend on the nature of the business; that is, what factors affect productivity and can be tracked and controlled.
Another productivity ratio, that is probably more oriented toward a manufacturing or production environment, is:
Utilization of Productive Capacity = Production Obtained / Production Capacity
Ratios of Effectiveness
Effectiveness has to do with comparing actual results with budgeted, forecast, or expected results. These ratios can be calculated on any item for which actual and expected results are available, and which are of interest in managing the business. Some examples include:
Forecast Profit / Actual Profit
Forecast Sales / Actual Sales
Forecast Production / Actual Production
Forecast Trade Receivables / Actual Trade Receivables
It should be noted that calculating the ratios as indicated above will yield a ratio greater than 1.0 if actual results are lower than forecast results. If you want to see a ratio of less than 1.0 if actual results are lower (for example, you want to see what percentage of forecast or budgeted profit you actually achieved) you would have to invert the ratios.
To see how efficiently you controlled expenses, you could calculate efficiency ratios of any individual expense item, or any grouping or total expenses:
Efficiency = Forecast Expenses / Actual Expenses
In addition to effectiveness and efficiency, quality control is another concern that can be expressed through ratio analysis:
Number of Customer Complaints / Number of Customers
Number of Late Deliveries / Total Orders Delivered
Quality Evaluation and Assurance Costs / Sales
Costs of Damages and Defects (Sales Returns) / Sales
Cost of Service After the Sale / Sales
Income Statements By Product-9
If you have the capability to generate income statements by product, or by product lines, you will have good insight as to where resources and efforts can be allocated more efficiently and profitably. If this information is not readily available from your accounting system, you may be able to prepare pro forma income statements by product.
Certain costs may be more readily assignable to specific products than others. Costs that may be allocable by product include:
Materials and supplies
Direct labor
Manufacturing cost
Sales commissions
Advertising and publicity
By breaking down sales by product, and then allocating these direct costs, you can determine a gross margin by product. This will be helpful in showing which products are contributing the most to your bottom line.
Certain costs may be more readily assignable to specific products than others. Costs that may be allocable by product include:
Materials and supplies
Direct labor
Manufacturing cost
Sales commissions
Advertising and publicity
By breaking down sales by product, and then allocating these direct costs, you can determine a gross margin by product. This will be helpful in showing which products are contributing the most to your bottom line.
Market Share and Participation By Product-8
If you have access to data on your particular market, you can determine your share of the market as:
Market Share = Your Company’s Sales / Total Sales in Your Market Sector
This ratio could be calculated in terms of volume of units sold, dollar value of sales, or both.
If your business involves more than one type of product, you can determine the relative importance of each product, in terms of your total sales, as:
Participation of Product A in Total Sales = Sales of Product A / Total Sales
To obtain an indication of how well you are renewing your product line, you can use the following ratio:
Level of Renewal of Product Line = Sales of New Products / Total Sales
The more information you have regarding the sales and costs of each of your own products, and the associated figures relating to your market sector, the more types of analyses you can perform.
By breaking down your actual sales by individual product, or line of products, and comparing these figures with the corresponding market figures, you can determine:
The growth of your sales of each product, period by period, and how your growth compares to the market.
Changes in your market share, by product by period.
Changes in the make-up of your sales – how much of your sales was for each product, and how is this evolving over time.
Market Share = Your Company’s Sales / Total Sales in Your Market Sector
This ratio could be calculated in terms of volume of units sold, dollar value of sales, or both.
If your business involves more than one type of product, you can determine the relative importance of each product, in terms of your total sales, as:
Participation of Product A in Total Sales = Sales of Product A / Total Sales
To obtain an indication of how well you are renewing your product line, you can use the following ratio:
Level of Renewal of Product Line = Sales of New Products / Total Sales
The more information you have regarding the sales and costs of each of your own products, and the associated figures relating to your market sector, the more types of analyses you can perform.
By breaking down your actual sales by individual product, or line of products, and comparing these figures with the corresponding market figures, you can determine:
The growth of your sales of each product, period by period, and how your growth compares to the market.
Changes in your market share, by product by period.
Changes in the make-up of your sales – how much of your sales was for each product, and how is this evolving over time.
Baseline-7
You can also analyze income statement accounts by using a baseline period. The baseline period could be your budget, a break-even point, your first year of operations, any period of actual results against which you want to compare other periods; or the baseline could be industry benchmark data or the results of a similar business, such as a competitor.
The results of any period you are comparing to the baseline period would be expressed in terms of a percentage of the corresponding amount from the baseline period. By doing this type of analysis over more than one period, you can see the absolute variances in the amounts of each element of the income statement as compared to the baseline, as well as relative variances from one period to another. For example, if your baseline indicates gross profit as 40% of sales, you will be able to track, period by period, how your actual gross profit compares (whether it is higher or lower than 40%) and how it is evolving (Is it going up or down?).
The results of any period you are comparing to the baseline period would be expressed in terms of a percentage of the corresponding amount from the baseline period. By doing this type of analysis over more than one period, you can see the absolute variances in the amounts of each element of the income statement as compared to the baseline, as well as relative variances from one period to another. For example, if your baseline indicates gross profit as 40% of sales, you will be able to track, period by period, how your actual gross profit compares (whether it is higher or lower than 40%) and how it is evolving (Is it going up or down?).
Income Statement Analysis-6
The income statement can also be broken down into its component parts and analyzed on a percentage basis.
Percentage Breakdown
Some of the principle items in an income statement, that could be expressed as a percentage of sales, for example, include:
Sales (100% in this example)
Cost of Sales
Gross Margin
Fixed Costs or Overhead
Net Income Before Interest and Taxes
Interest Expense and Financing Costs
Net Income Before Income Tax
Income Tax
Net After-Tax Income
By doing a comparative analysis based on percentages over different periods, you can see how the different components of the income statement are evolving. Here again, graphs would be a useful visual tool.
Percentage Breakdown
Some of the principle items in an income statement, that could be expressed as a percentage of sales, for example, include:
Sales (100% in this example)
Cost of Sales
Gross Margin
Fixed Costs or Overhead
Net Income Before Interest and Taxes
Interest Expense and Financing Costs
Net Income Before Income Tax
Income Tax
Net After-Tax Income
By doing a comparative analysis based on percentages over different periods, you can see how the different components of the income statement are evolving. Here again, graphs would be a useful visual tool.
Debt Characteristics-5
The total amount of debt your business is carrying is important, but it is also important to know what type of debt you are carrying. In this regard, it can be useful to prepare an analysis, or table of debt characteristics.
Some of the data you may want to include in this type of analysis include:
Type of debt (secured and unsecured bank loans, revolving lines of credit, bonds)
Amount of each type of debt
Interest rate (fixed, variable, and percentages)
Due dates
Annual debt servicing cost
Annual installments
Collateral provided
Having a clear picture of the structure of your debt will allow you to make decisions regarding potential alternative sources of financing, if necessary.
Some of the data you may want to include in this type of analysis include:
Type of debt (secured and unsecured bank loans, revolving lines of credit, bonds)
Amount of each type of debt
Interest rate (fixed, variable, and percentages)
Due dates
Annual debt servicing cost
Annual installments
Collateral provided
Having a clear picture of the structure of your debt will allow you to make decisions regarding potential alternative sources of financing, if necessary.
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