Financial Analysis Using Ratios FAQs

Applies to: [x] C&P Classic [x] C&P Pro [x] Job Tracker [x] C&P SQL [x] My C&P! See also:

Summary: Frequently asked questions about performing financial analysis using Clients & Profits. Because Clients & Profits is a complete accounting system, it helps you analyze the financial performance of your shop more quickly and easily than ever before. The basis of financial analysis is to use the costs, billing, and expenses everyone enters into Clients & Profits to identify potential problems. This analysis also shows you whether your finances are on track or not, then helps with planning. By using simple math, you can easily calculate and create liquidity, profitability, debt and activity ratios. This FAQ list describes the ratios which are typically most important to an advertising agency or design firm. It's not meant as a comprehensive guide, or a replacement for professional financial advice. Your CPA is an excellent source for more information about financial ratios and analysis. Where does the data for this kind of financial analysis come from? How do I know that the numbers I'm looking at are accurate? What kind of financial ratios are most meaningful? What are the best measures of profitability? What are good measures of activity? What are good measures of debt? Q. Where does the data for this kind of financial analysis come from? The data you need for ratio analysis is already on your balance sheet and income statement, which can be printed from Clients & Profits any time. You can use the financial reports for different months to evaluate the company's performance by comparing today's financial statements to previous statements. Also, you can use your numbers to compare against financial data from other agencies.   Q. How do I know that the numbers I'm looking at are accurate? The axiom "garbage in/garbage out" really applies here. Be sure you're using good information--use only balanced financial statements that you've audited. Remember, too, that a single ratio doesn't paint the whole picture. Look at different ratios, and the same ratio at different times. One ratio can be skewed by an unusual situation. For example, the debt ratio of a new company may be unusually high. That's good information, but hopefully the additional risk is part of the overall consideration for starting the company.   Q. What kind of financial ratios are most meaningful? Liquidity ratios measure the ability of a company to pay its bills. Generally, the higher the ratio, the more solvent the company.   Net working Capital = Current Assets - Current Liabilities By subtracting current liabilities (bills to be paid soon) from current assets (assets you'll use to pay the bills), you'll find out the amount of capital (money) that you have to work with. This is valuable for cash flow management. Comparing the net working capital at different times also helps to evaluate and plan the agency's operations. If income is seasonal, for example, the net working capital calculation will quantify how much more money is available after the busy season, or how much of a shortfall to anticipate in the off-season Current Ratio = Current Assets/Current Liabilities The current ratio is one of the most commonly used financial ratios. A current ratio of two (current assets which are double the amount of current liabilities) is often considered acceptable. A current ratio of 1 means the company has a net working capital of 0 -- nothing leftover after paying the bills. Q. W hat are the best measures of profitability? Profitability ratios measure return while the other ratios measure risk. The income statement is the most useful financial analysis tool. Percentage income statements, like the one in Clients & Profits, are especially helpful when compared to other fiscal periods or information from other agencies. Both gross profit margin and net profit margin are reported on the income statement. Percent Income Statements Income statements quickly get you to "the bottom line". Gross profit margin is the percentage of income left after deducting job costs. Net profit margin is the percentage of income after all expenses have been deducted. Profit margins are calculated on income statements using the calculation, profit/income. Cost and expense account balances are also expressed as a percentage of income. You can choose to print percentages based on expense/income (standard) or expense/gross profit (AGI) Compare month-to-date percentages on the income statement to year-to-date percentages on the same statement. If the profit margin or any of the percentages vary, it's a flag that there's a change in the company's finances. Also, compare the percentages to other agencies to see how your shop stacks up against others. Average percentages are available in trade publications such as the AAAA Annual Analysis of Agency Costs. Return on Investment (ROI) = Net Profits After Taxes/Total Assets To show how efficiently assets are being used, ROI compares the company's total assets (investment) to the net profit. If the company has lots of assets, but a weak net profit, the owners aren't getting a high return on their investment. Return on Equity (ROE) = Net Profits After Taxes/Equity The ROE compares what the owners have tied up in the company to the net profit for a ratio that's similar to ROI. Q. What are good measures of activity? Vendor and client agings are the most important tools an agency has for checking the speed of invoice payments. Those reports are easily printed from the Snapshot menu. The agings show at a glance which client or vendor accounts are overdue. Ratios which measure the speed at which accounts are converted into cash or income are: Average Collection Period = Accounts Receivable/Average Income Per Day The accounts receivable balance is divided by average income per day to show how long it takes to collect an average account. Find average income per day by dividing income for the period by the number of days in the period. If you want to see the average collection period for the past year, use the period 12 balance sheet and income statement. The calculation is: accounts receivable balance/YTD income/360. Total Asset Turnover = Income/Total Assets Total asset turnover, like ROI, shows how efficiently the company's assets have been used. The ratio is only meaningful when compared to former periods or to industry standards. CFOs and lenders would have more interest in this ratio than owners of small shops. Q. What are good measures of debt? Use debt ratios to measure degree of debt and the company's ability to pay its debts. In general, the higher the ratio, the more debt the firm has and the less solvent it is. Another way to look at a higher ratio is the firm has more financial leverage -- a greater amount of other people's money is being used to generate profits. The manager needs to decide if the company's cash flow can support high principal and interest payments.   Debt Ratio = Total Liabilities/Total Assets The debt ratio measures the proportion of total assets financed by creditors. Debt-Equity Ratio = Long-Term Debt/Equity Lenders and stockholders are interested in the debt-equity ratio. Because it analyzes long-term debt, it's a good indicator of financial leverage. Search the Daily Q&A database