From Jeffrey Davis' Desk...

Everyone is asking us, is the economy changing? It appears that the growth rate is leveling off; and we are in a transition. What remains in question is which companies are heading for a soft landing or a more abrupt and disruptive slow down. The challenge for owners is to grow the business and take advantage of an uncertainty in the economy. Senior Consultant Stephen Kotler addresses a key skill necessary for ensuring continued growth that is often ignored by entrepreneurs: Financial Analysis. A properly designed accounting system facilitates an owner's ability to analyze company performance and plan for the future. Steve reviews the foundations and uses for Financial Analysis in this month's issue.

I want to wish all of Mage's friends and associates the best of luck as we face new challenges and opportunities in the new millennium.

Jeffrey S Davis

Chairman and CEO

STRATEGIC STATEMENTS
Tools for Entrepreneurs

Business today faces a growing sense of uncertainty. The stock market has declined amidst fears of earnings warnings and downgrades while all indicators show signs of a changing economy. Sales growth rates are declining as consumers and customers fear an economic slowdown. This economic environment has put pressure on entrepreneurs and business owners to ensure their businesses continue to grow and prosper. Strategic navigation through periods of economic uncertainty requires that management fully understand its business and performance. Leaders who possess the ability to analyze and interpret their company's financial performance have a roadmap for making business decisions that can ensure profitability and growth in the most challenging of times.

Entrepreneurs frequently need to answer critical issues such as: Why has my business been successful? Why is my business unprofitable despite continued sales growth? Why does my business always seem to be operating in a cash crunch? Entrepreneurs can answer these critical strategic questions by obtaining accurate and timely financial reports and by performing an analysis using basic financial planning models.

Entrepreneurs predominantly face five major issues in the managing of their business: Profitability - Is the company making money? Cash Flow - Does the company generate enough cash to cover operational needs? 3. Performance - Does the company use budgets and forecasts to benchmark performance and achieve its goals and objectives? 4. Undercapitalization - Does the company have enough capital to operate effectively? 5. Growth - What rate and type of growth is most beneficial to the company?

Numerous methods exist that enable entrepreneurs and business owners to evaluate performance by comparing current financial statistics to historical and competitive benchmarks. The most useful tools include:

• Ratio Analysis
• Comparative Analysis
• Percentage Analysis

Ratio Analysis Ratio: Analysis involves the calculation of ratios utilizing figures on the Balance Sheet and Income Statement to evaluate the performance of a company.

Liquidity Ratios: Liquidity Ratios gauge a business's ability to pay its short-term obligations with its short-term assets. The most common ratios include the Current Ratio or Working Capital Ratio (Current Assets divided by Current Liabilities) and the Quick Ratio or Acid Test Ratio (Cash + Short-term investments + Accounts Receivable less than 90 days divided by Current Liabilities). Generally, a Current Ratio greater than 1:1 and a Quick Ratio greater than 0.5:1 indicate that a company is sufficiently liquid to continue operating.

Activity Ratios: Activity ratios indicate how effectively a company is managing its assets. The most common ratios include Accounts Receivable Turnover (Net Sales divided by Average Accounts Receivable), Accounts Receivable Collection Period (365 divided by Accounts Receivable Turnover), Inventory Turnover (Cost of Goods Sold divided by Average Inventory), Days Inventory on Hand (365 divided by Inventory Turnover), and Operating Cycle (Accounts Receivable Collection Period + Days Inventory on Hand). These ratios are measured in 'turns', i.e. the number of times the asset has been collected or sold in a period, or 'days' i.e. the number of days needed to collect or sell the asset. Generally, higher turnover rates and lower collection periods or days inventory on hand indicate higher quality assets that are more readily convertible into cash to sustain the company.

Profitability Ratios: Profitability Ratios measure the degree of success of a business over time. The most common ratios include Gross Profit Ratio (Gross Profit divided by Net Sales) or remainder of sales after the associated costs of those sales has been deducted; Return on Equity (Net Earnings divided by Average Common Equity) or rate of return on equity invested in the business; and Return on Assets (Net Earnings divided by Average Total Assets) or rate of return on assets employed in operating the business. Generally, larger percentages imply a more profitable business.

Coverage Ratios: Coverage ratios indicate the degree of protection that creditors and investors hold in a business, and provide information on how much financial leverage (debt) may be used by the company. The most common ratios include Debt to Equity Ratio (Total Debt divided by Total Equity), and Debt to Assets (Total Liabilities divided by Total Assets). Generally, ratios of 1:1 or less indicate that a company does not use a disproportionate amount of debt to finance its operations, and that future growth can be achieved by borrowing additional money. Other ratios include Times Interest Earned (Earnings Before Interest and Taxes divided by Interest Expense), Book Value per Share (Shareholders' Equity divided by Common Shares Outstanding), and Cash Flow per Share (Cash Flow from Operations divided by Common Shares Outstanding). Generally, larger ratios indicate the ability of the company to generate earnings and cash flow to finance current operations and fund future growth and expansion.

Limitations: Ratios are widely used by managers, creditors and investors. Used correctly, ratios can tell a lot about a company and its operations. However, ratios are just one number divided by another, so it is difficult to imagine that these numbers can accurately reflect the full picture of something as complex as a modern corporation. No one ratio itself will paint a true financial picture of the company. For example profitability ratios like Return on Equity (ROE) say nothing about the risks a company has taken to generate it. Because ROE looks only at the return while ignoring risk, it can be an inaccurate yardstick of financial performance.

Analysis using a combination of ratios will lead to more valid strategic decisions. It is useful to think of ratios as pieces to the puzzle that forms your business. One or several pieces might not seem to fit at first but when combined with other knowledge of a company's management and economic circumstances, ratios can tell a revealing story.

Another point to remember is that a ratio has no single correct value. The observation that a company's particular ratio is too high, too low or just right depends on the perspective of the analyst reviewing the data. For example from the perspective of a short term creditor, a high current ratio is a positive sign because it shows that the company has the ability to pay its obligations. Yet the owner of the firm may see this as a negative sign that the company's assets are being deployed too conservatively. The important point here is not whether or not the current ratio is too high but whether the chosen strategy is the best one for the company under consideration. As with any other financial data, the quality of financial ratios is dependent on the quality of the numbers they are derived from. Keep in mind that financial information is based on historical costs, and does not reflect the impact of non-financial determinants such as inflation, competition and technology.

Comparative Analysis: Comparative Analysis or Horizontal Analysis examines the proportion of change in Income Statement items over a period time, usually years, allowing analysts to draw firmer conclusions about the firm's financial health. Trends are usually compared between more than one item since interrelationships exist between Income Statement items. For example, a comparison of Sales and Gross Profit dollars and growth rates over time may indicate whether additional sales from new products or services are generating additional profit. It is also very useful to compare ratios calculated to those from outside sources including banking and finance publications (Dun and Bradstreet, Moody's, Standard and Poor's or Robert Morris Associates), government agencies (Department of Commerce or OSHA), as well as industry trade groups or associations that regularly survey their members for 'State of the Industry' analysis. Information from these sources can be used as a benchmark to gauge the performance of a company against its competitors. It is important to note that company specific differences can result in justifiable deviations from industry norms.

Percentage Analysis: Percentage Analysis or Vertical Analysis entails the comparison of one item relative to a base item on the Income Statement. The most commonly used base item is Net Sales. For example, Cost of Goods Sold, Sales and Marketing expenses and General and Administrative expenses are frequently calculated as a percentage of Net Sales. Analyzing these percentages using Comparative Analysis provides additional information on how these expenses vary over time as well.

Other Tips: Entrepreneurs typically focus on the Income Statement to evaluate how they are managing their business. In most situations, the Cost of Goods Sold is the largest expense on this statement, and as such, deserves a lot of attention. Focus should be placed on items that directly affect production costs. Savings of even a small percentage in Cost of Goods Sold will translate into a dramatic increase in your bottom line. It is equally important to focus the Balance Sheet since it indicates the financial health of the company.

An executive is like the captain of a ship, without good financial statements and the thoughtful analyses you will never navigate your company through the next big storm. By comparing your company's ratios to rules of thumb, industry averages and changes over time you will have the ability to run a successful business during the most difficult of times.

Stephen Kotler, CA, CPA
Senior Consultant
Mage, LLC