Part Five

TOOLBOX

WHICH RATIOS ARE MOST IMPORTANT TO YOUR BUSINESS?

Certain ratios are generally seen as critical in certain industries. Retailers, for instance, watch inventory turnover closely. The faster they can turn their stock, the more efficient use they are making of their other assets, such as the store itself. But individual companies often like to create their own key ratios as well, depending on their circumstances and competitive situation. For example, Joe’s company, Setpoint, is a small, project-based business that must keep a careful eye on both operating expenses and cash. So which ratios do Setpoint’s managers watch most closely? One is homegrown: gross profit divided by operating expenses. Keeping an eye on that ratio ensures that operating expenses don’t get out of line in comparison to the gross profit dollars the company is generating. The other is the current ratio, which compares current assets with current liabilities. The current ratio is usually a good indication of whether a company has enough cash to meet its obligations.

You may already have some key ratios that you watch closely. If not, think about what they might be. Ask your accountant and banker what numbers they study when they look at your business. Think about the numbers that keep you up at night and any others that tell you about the critical aspects of your business.

THE POWER OF PERCENT OF SALES

Is there a ratio built right into your company’s income statement? Many companies do just that: they express each line item not only in dollars but as a percent of sales. For instance, COGS might be 68 percent of sales, operating expenses 20 percent, and so on. The percent-of-sales figure itself will be tracked over time to establish trend lines. Companies can pursue this analysis in some detail—for example, tracking what percent of sales each product line accounts for, or what percent of sales each store or region in a retail chain accounts for. The power here is that percent-of-sales calculations give a business owner and her managers much more information than the raw numbers alone. Percent of sales allows an operations manager, for example, to track his expenses in relationship to sales. Otherwise, it’s tough for the manager to know whether he is in line as sales increase and decrease.

If your accountant doesn’t break out percent of sales, try this exercise: locate your last three income statements, and calculate percent of sales for each major line item. Then track the results over time. If you see certain items creep up while others creep down, ask yourself why that happened—and if you don’t know, dig deeper until you find out. The exercise can teach you a lot about where your operations can be improved. And next time you talk to your accountant, ask him to include that column in your income statement. For him, it is simply a matter of inserting the formula into the statement. For you, it is a powerful tool to improve your business.

SUSTAINABLE GROWTH RATE

Like the financial statements themselves, ratios fit together mathematically. We won’t go into enormous detail here because this book isn’t aimed at financial professionals. But one relationship among ratios is worth spelling out because it shows so clearly what we have been saying, namely that you and your managers can affect your business’s ability to grow through internal financing by managing some key ratios.

In 1957 David Packard of Hewlett-Packard gave a landmark speech titled “Growth from Performance.” In the speech Packard explained that HP was able to grow its revenue from $2.3 million in 1950 to $28 million in 1957 by maintaining some key ratios that supported this growth internally. This presentation led to a calculation that is now called the sustainable growth rate for a business.

The sustainable growth rate for a business is an estimate of the amount of growth a company can sustain without requiring outside equity investment. The calculation is simple, even though it may not sound so. First, take a company’s return on equity. Multiply that figure by the ratio of retained earnings to dividends. The result gives you the sustainable growth percentage that can be funded internally at current debt ratios.

To calculate return on equity, we are going to use the relationships among net profit margin, total asset turnover, and leverage (calculated as assets over equity) to show you the individual elements you can affect. Here’s how to break down the process.

First, break down return on assets into the following:

The first term, net income divided by revenue, is of course net profit margin percentage, or return on sales. The second term, revenue divided by assets, is asset turnover, discussed in chapter 22. Net profit margin multiplied by asset turnover equals ROA.

Then multiply the elements of ROA by assets/equity, and you will get return on equity (ROE). If you retain 100 percent of your earnings, ROE is your sustainable growth rate. Here is a summary of the relationship:

This relationship assumes that you retain all your earning for growth. So let’s say your net margin is 12 percent, your asset turnover is 1.50, and you have an equal amount of debt and equity in the business (so that the ratio of total assets to equity is 2). In this case, your sustainable growth percentage would be:

12%×1.50×2 = 36% (assuming you do not pay shareholder dividends)

The equation shows explicitly that there are three moves to the hoop, where the hoop is to increase your sustainable growth rate. One is to increase net profit margin, either by raising prices or by delivering goods or services more efficiently. That can be tough if the marketplace you operate in is highly competitive. A second is to increase the asset turnover ratio. That opens up another set of possible actions: reducing average inventory, reducing days sales outstanding, and reducing the purchase of property, plant, and equipment. Third, you can increase your ability to grow without giving up equity by increasing the use of debt. If you can’t improve your net profit margin, working on the other two ratios—that is, managing the balance sheet—may be your best path to beating the competition and improving your sustainable growth rate.