FINANCIAL STATEMENTS AS A MANAGEMENT TOOL

This article shows you how to use your financial statements to answer ten important questions. In addition, three case studies provide examples of how financial statement analysis works. Figure 1 shows several ratios that are commonly used for analyzing financial statements. Keep in mind that the ratios shown in Figure 1 are only a sample of dozens of widely-used ratios in financial statement analysis. Many of the ratios overlap.

To illustrate financial statement analysis, we will use the financial statements of K-L Fashions, Inc. K-L Fashions is a direct mail order company for quality "cut and sewn" products. Their financial statements are presented in Figure 2. Like most small businesses, they have a relatively simple capital structure and their income statement reflects typical revenues and expenses. Inventory consists primarily of merchandise obtained under contract from approved garment makers and held for resale. K-L Fashions uses trade credit for purchases, but its sales consist almost entirely of credit card sales. Consequently, we see a very low accounts receivable balance compared with accounts payable. Some of the items that would normally be seen on financial statements have been consolidated to simplify the presentation.

Financial statement analysis can be applied from two different directions. Vertical analysis is the application of financial statement analysis to one set of financial statements. Here, we look "up and down" the statements for signs of strengths and weaknesses. Horizontal analysis looks at financial statements and ratios over time. In horizontal analysis, we look for trends - whether the numbers are increasing or decreasing; whether particular components of the company's financial position are getting better or worse.

We will look at the financials from the perspectives of four different groups: owners, managers, short-term creditors and long-term creditors.

Owners

Although owners of small businesses often are also the managers, the initial concern is with owners as investors in the business. Owners use financial statement data as a way to measure whether their money is working as hard in the business as it would in an alternative investment. The data can also tell how well you or your managers have managed the firm's assets. Thus, the ratios that are of greatest interest to you as owner/investor are those that measure profitability relative to (1) your own investment in the firm and (2) the total amount invested in the firm from both your capital and borrowed funds.

1. How well is the company doing as an investments?

The Return on Investment (ROI) [Net Income / Owners' Equity (Average)] measures the profitability of the firm on owner invested dollars. Net income is the after-tax return. The owners' equity (or capital) account is the investment. It is the amount you have contributed directly to the business and amounts that you have reinvested via undistributed profits.

ROI gives an indication of the past earning power of your investment and can be used to compare the company's performance in this regard to other companies in the industry. It should also be compared with other investment opportunities open to you. If your company typically generates a return of 10 percent and you can invest elsewhere at 15 percent, it doesn't make sense from a purely economic standpoint to keep your funds tied up in the company.

K-L Fashions' ROI for fiscal 1991 was about 12.7 percent [$147,430 / $1,157,150]. Average equity is used as the denominator to approximate the amount available for use in generating net income over the course of the entire year. Taken by itself, this figure is neither impressive nor disturbing. The median "return on net worth" calculated by Dun and Bradstreet (D&B) for catalog and mail-order houses was 22.3 percent.

Figure 1. Financial Ratios

Figure 2. K-L Fashions, Inc. Balance Sheet

The trend established over the last three years is more important. Comparing the 1991 return with the two preceding years, there is a sharp drop from 43.4 percent in 1989, to 28.2 percent in 1990, to 12.7 percent in 1991.

2. How well has management employed the company's assets?

The Return on Assets (ROA) [Net Income - Average Total Assets] measures the profitability of the firm on all invested dollars. That is, it measures how well the firm's assets have been employed in generating income. This measure is omewhat broader than the return on equity because it compares the returns on total capital. This includes the capital that you and the creditors have provided.

What constitutes a satisfactory ROA? It depends on the types of assets and their end use. Once again, since companies within a given industry tend to employ similar assets, your ROA should be measured against industry norms. K-L Fashions' ROA for fiscal 1991 was 8.4 percent [$147,430 --. $1,761,660] compared with a median of 10 percent for the industry for the most recent period. Again, K-L Fashions falls short. We also see a declining ROA over a three-year period: 25 percent for 1989, 18.3 percent for 1990, and 8.4 percent for 1991.

Managers

Managers, too, are interested in measuring the operating performance in terms of profitability and return on invested capital. If they are not owners, managers must still satisfy the owners' expectations in this regard. As managers, they are interested in measures of operating efficiency, asset turnover, and liquidity or solvency. These will help them manage day-to-day activities and evaluate potential credit customers and key suppliers. Manager ratios serve as cash management tools by focusing on the management of inventory, receivables and payables. Accordingly, these ratios tend to focus on operating data reflected on the profit and loss statement and on the current sections of the balance sheet.

3. Are profits high enough, given the level of sales?

In other words, how efficiently is management conducting operations? The Net Profit Margin [Net Income / Sales (or Return on Sales)] is a measure of the relative efficiency of the company's operations after deducting all expenses and income taxes. It measures the proportion of each sales dollar that results in net income.

The average for this ratio varies widely from industry to industry. To serve as an aid in management, the company's net profit margin should be compared with that of similar companies in the same industry, and with the company's past figures. The manager should monitor this ratio and investigate potential problems when the ratio begins to fail below the industry average or has shown continued deterioration during the most recent quarter or two. If both conditions exist, management Is likely facing a problem that requires immediate attention. Incidentally, most bank loan officers use the return on sales ratio as a key indicator in making term loan decisions. A deteriorating ratio is often seen as an indication of impending business distress.

The fiscal 1991 net profit margin for K-L Fashions was 2.4 percent [147,430 / 6,039,7501]. By comparison, the median return on sales for the industry, as reported by D&B, was 4.0 percent, meaning that another of the company's profitability measures is below the industry norm. Equally troubling is the downward trend in the net profit margin since 1989. In fiscal year 1990, the net profit margin was 5.3 percent, down from 7.1 percent for 1989. Over this period, profits declined 54.3 percent, despite a 32.5 percent increase in sales. If the company were maintaining operating efficiency, increases in sales would result in increases in profits. (This scenario is generally an indication that some operating expenses are getting out of hand.) An examination of K-L Fashions' income statement suggests that selling, general and administrative expenses, which grew by 55 percent over the past two years, could be the cause of the decreased profitability. Because the financials for K-L Fashions only provide general categories, it is difficult to assess the cause of the increase in this expense category.

4. How well are the company's assets being employed to generate sales revenue?

The Asset Turnover ratio [Sales - Average Total Assets] indicates the relative efficiency with which managers have used the firm's assets to generate output, and thus, it helps answer this question. Here again, what is acceptable or appropriate varies from industry to industry. Usually, however, a higher ratio is better. A very high turnover rate could signal an opportunity for expansion or the need for early replacement of assets. It could also mean that the company is in a high-volume, low-margin industry.

K-L Fashions' asset turnover ratio was 3.4 times [$6,039,750 - $1,761,660] for fiscal 1991 and, despite a decrease from fiscal 1990, remains at a level comparable with fiscal year 1989. This means little by itself; but compared with the industry average of 3.1 times, we might conclude that sales performance is probably satisfactory for the amount of resources available.

Neither the profit margin nor the asset turnover by itself provides an adequate measure of operating efficiency or profitability. But multiplying the profit margin by the asset turnover ratio gives us the "Return on Assets" ratio or earnings power on total assets. This ratio is the same as the ROA computed for the owners but is presented in a form that managers often find more useful. It blends, in one number, all the major ingredients of profitability; yet it allows the manager to see how the individual components contribute. Thus, there are two basic ingredients to profitability: asset turnover and profit margin. An improvement in either without changing the other - will increase the return on assets.

What can managers do to increase the returns on assets and owners' investments? The return on assets will increase by either an increase in the asset turnover or an increase in the profit margin. Three separate items are involved in the calculation: sales, net income and assets. However, since net Income is simply sales minus expenses, the three individual items subject to management control are sales, expenses and assets. Either increasing sales, decreasing expenses, or decreasing assets, while holding the others constant, will improve the ROA and with it the ROI Given K-L Fashions' most recent financial statement, it appears the most fruitful efforts would consist of controlling costs to increase both profits and the profit margin.

Notice that it doesn't require sophisticated analysis to come to this conclusion. This illustrates, however, one role of financial statement analysis: to highlight areas that need management attention. Once problem areas are highlighted, solutions can be obvious. This is why a common-sense approach of increasing sales and lowering expenses works to improve profitability.

5. Are receivables coming in too slowly?

The Average Collection Period [(Average A/R Annual Credit Sales) * 365] of receivables tells how many days, on average, customers' trade accounts (AIR) are outstanding. The average collection period is a measure of both liquidity and performance. As a measure of liquidity, it tells how long it takes to convert accounts receivable into cash. As a measure of performance, it I indicates how well the company is managing the credit extended to customers.

Whether the average collection period is too high will depend on what kind of credit terms the company extends to its customers and how appropriate those terms are. If accounts are expected to be paid in 30 days, a 34-day average would be considered very good. Most customers tend to withhold payment for as long as the credit terms allow. This practice, along with some ever-present slow accounts, can cause the average collection period to exceed the stated limit by a week to 10 days and should not be a matter of concern. An average collection period of 48 days in this case, however, could be a danger signal. Customers who are slow in paying their bills, may never pay at all.

As the balance sheet shows, K-L Fashions' accounts receivable are insignificant. The average collection period relating to all sales was .5 days [($7,785 -$6,039,750) x 365] for 1991 and less than one-half day for each of the prior two years. This rapid turnover of receivables is understandable, because K-L Fashions' "credit sales" are largely bank credit card sales. Cash management in this area seems to be good in that no time is wasted in getting credit card invoices and personal checks credited to the company's account.

Because accounts receivables balances for K-L Fashions comprise a minor portion of the company's total assets, this ratio is not particularly useful as a cash management tool to its managers. And, as stated previously, a common sense approach to financial statement analysis must be maintained. If, like K-L Fashions, your business has few receivables, then analysis of them would not be worthwhile. Another example is service industries that have no inventory. With no inventory, the next section of analysis is irrelevant.

6. Is too much cash tied up in inventories?

The Inventory Turnover [Cost of Goods Sold Expense / Average Inventory] ratio is used to measure the speed with which inventories are being sold and is useful in managing inventory levels. How much inventory should the company keep on hand? The answer depends on making a delicate trade-off between anticipated near-term sales, the costs of ordering and holding inventory, the cost of stock-outs, etc. It also depends on the expected future availability of goods from the company's suppliers. In either case, excessive cash tied up in inventories reduces a company's solvency.

This ratio is vital for small-business managers who must make very effective use of the limited capital available to them. just what is an appropriate turnover rate depends on the industry, the inventory itself, and general economic conditions. For example, the Brokaw Division of Wausau Papers (in Brokaw, Wisconsin) often has one to three years' worth of raw material inventory (logs) on hand. Because the road and weather conditions limit the time when wood can be received in Northern Wisconsin, Wausau Papers is forced to have a very slow inventory turnover rate for raw materials at that particular plant. However, finished goods (cut, colored paper) turnover every 28 days.

If inventory turnover for the firm is consistently much slower than the average for the industry, then inventory stocks probably are either excessively high or contain a lot of obsolete items. Excessive inventories simply tie up funds that could be used to make needed debt payments or to expand operations. An extremely high turnover rate could be a sign of stock-outs - not being able to fill a customer's order because the goods are not on hand. However, on the positive side, if neither stock-outs nor collections are a problem, then a high ratio can be good.

K-L Fashions' balance sheet also shows that, other than plant and equipment, more dollars have been invested in inventory than any other asset category. Given the type of firm, this is not unusual. However, the inventory turnover rate for the company is only 4.5 times per year [$3,573,070 - $797,860], meaning that it takes an average of 81.5 days [365 -- 4.5] for the company to sell its inventory once it is purchased. This translates into about 81 days of inventory. Does this indicate too much inventory for the rate at which it is selling? On the surface it might seem excessive, considering that inventory balances should be at a low point after the Christmas sales rush. A look at similar companies, however, reveals that K-L Fashions' turnover is not much slower than the industry average of 5.1 times (or 72 days). Even with this level of inventory, management stated in its annual report that the company was able to fill only 82 percent of orders from goods on hand.

Short-term creditors

Short-term creditors, including managers who extend credit to trade customers, are interested in the solvency of borrowers or customers. As a result, they tend to focus on the current section of the balance sheet. The same calculations that a manager does on his/her own financial statements can also be done on a debtor's financial statements. The most widely used financial ratios used to answer questions of short-term solvency are the current ratio and quick ratio.

7. Does this customer have sufficient cash or other liquid assets to cover its short-term obligations?

The Current Ratio [Current Assets / Current Liabilities] is one of the most frequently used measures of solvency. It shows the relationship between current assets and current liabilities. Current liabilities are obligations that will come due in the next 12 months. Current assets are assets that are expected to be converted to cash in the same period. This ratio is widely used to provide one indication of whether a prospective customer or borrower is a good short-term credit risk. An old rule-of-thumb says that the current ratio should be at least 2.0 to provide an adequate margin of safety. Whether this ratio is high enough, however, depends on the type of company involved and, to some extent, on the time of year. (Airlines often have current ratios under 1.)

What constitutes a good ratio also depends on the composition of the current assets relative to the due dates for the current obligations. If inventory makes up a significant portion of current assets and it is moving slowly, a higher than-average ratio may hide potential liquidity problems. Thus, the quick ratio should also be evaluated.

The Quick Ratio [Cash + Marketable Securities + A/R / Current Liabilities] (or acid test) is a somewhat more accurate guide to short-term solvency. This ratio is the same as the current ratio except that it excludes inventory and prepaid expenses - the least liquid of the current assets. It provides a more penetrating measure of solvency than does the current ratio. If receivables turn over rapidly, a quick ratio of 1.0 or a little higher is probably adequate. A grocery store will often have quick ratios of .25 to .50 and current ratios that exceed 2.

Suppose we are a supplier to K-L Fashions. KL Fashions' current ratio at the end of fiscal year 1991 was 1.8 times ($1,078,240 - $607,740), down from 2.3 times the previous year and below the industry median of 2.5 times. However, even if the latest current ratio were 2.3 or better, it alone would not provide us much comfort because inventory comprises so much of the company's current assets.

K-L Fashions' latest quick ratio is .5 times ($284,730 $607,740) compared with an industry average of 1.0 times. This is a more stringent and valid test of liquidity in this case. If the ratio is at least 1.0 times (which means that liquid assets equal current liabilities), we can usually assume that the company has few short-term payment problems. At .5 times, however, we would want to look at other indicators of future cash flows. Any small company with these kinds of numbers may be required by creditors to provide a short-term projection of future cash receipts and disbursements.

8. How quickly does the prospective credit customer pay its bills?

Suppose that, on balance, we find the company's short-term solvency to be acceptable. Before agreeing to supply the company on a credit basis (or establishing credit terms for the company), we should try to determine how quickly the company normally pays its bills. The Average Age of Payables [(Average Payable - Net Purchases) * 365] helps answer this question. That is, having determined that a company has the capacity to pay its short-term obligations as they come due (through the current or quick ratios), it is also important to evaluate its payment practice. In a manner similar to calculating the average collection period for accounts receivable, one can compute the average "age" of a company's payables, which is the average number of days it takes to pay its invoices. The age of the potential customer's payables will give a reasonable estimate of how soon a creditor can expect to be paid. This is particularly important for the small business that has just landed a major customer.

A large corporation is likely to use very effective (from its own standpoint) cash management procedures to ensure prompt payment from its customers while delaying payment to its suppliers as long as possible. Unless the small business is a critical supplier of its large corporate customer, that corporation may not accelerate its payment cycle to meet the supplier's cash flow needs. That's why it is critically important for the decision-making process of the small business owner/manager to be able to estimate the potential customer's payment cycle.

To calculate the average age of payables for K-L Fashions, we need to estimate purchases because they are not reported directly in the statements. Cost of goods sold (which is on the income statement) equals beginning inventory, plus net purchases, minus ending inventory. Therefore, purchases equal the cost of goods sold ($3,573,070) minus beginning inventory ($857,090) plus ending inventory ($738,630), or about $3,454,610. Using this calculation, we can calculate that the average age of K-L Fashions' payables is [($311,060 / $3,454,610) x 365]= 32.9 days. If K-L Fashions were a potential customer, we should not expect it to pay our invoices much sooner than 33 days.

Long-term creditors

Bankers and other long-term creditors want to be assured of receiving interest and principal when each become due. These creditors are particularly interested in the earning power and the present and future financial capacity of the borrower.

9. As a potential or present long-term borrower, is the company's debt load excessive?

If the company's debt load is too high - it is highly leveraged - it means that creditors of the firm have a disproportionately high share, and owners have a disproportionately low share, of the inherent risk of being in business. A simple measure of the "risk load" is the Debt-to-Equity (D/E) [Total Debt / Total Equity] ratio. This ratio relates the investment provided by creditors to that provided by owners. It indicates who is the major risk-bearer in this business. That is, if the D/E ratio is 10:1, it means that creditors have $10 invested in this business for every $1 that the owner has invested. Since the owner is making the decisions, the creditor in this case is in an extremely precarious position. The creditors in this case stand to lose 10 times as much as the company's owners. Therefore, the owner might be more willing to take more speculative risks.

Conversely, if the ratio is 1: IO, it means that the owner has more to lose. The creditors for this type of company would feel safer knowing the owner has a bigger personal stake. From a creditor's standpoint, a lower D/E ratio is better. A long-term creditor tends to be skeptical of borrowers' good intentions or judgment when the company is highly leveraged or is seeking new funds that will cause it to become highly leveraged. Owners should use this ratio to view their companies as a long-term creditor would, and should seek to keep the debt-to-equity relationship within industry norms.

K-L Fashions' D/E is .6 ($685,740 / $1,168,260), compared with a median D/E of .6 for the industry. This would normally indicate relative financial strength. However, we should note that those liabilities that do not need to be paid or settled in the near term, constitute only about 1 1 percent of total liabilities. Except for advance payments on orders, the other 89 percent are short-term obligations. Consequently, this ratio is less important in this case than the short-term solvency measures - even to the company's long-term creditors. This reinforces the concept that ratio analysis should be applied with common sense.

10. Are earnings and cash flow sufficient to cover interest payments and provide for some principal repayment?

The Times Interest Earned (TIE) [Income + (Interest + Taxes) / Interest Expense] ratio may be used to help answer this question. Note that this ratio uses income before interest and income taxes are subtracted because this is the amount of income available to cover interest. The larger the number, the easier it will be for the debtor company to suffer an earnings depression, and still make its interest payments. The TIE measures the bank's safety in terms of the likelihood that it will continue to receive periodic interest payments. The TIE does not, however, indicate how well total debt payments are covered.

The Cash Flow to Total Liabilities [Operating Cash Flow / Total Liabilities] ratio is preferred by many bankers as a measure of earnings power relative to all debt. This debt coverage ratio depicts a company's debt repayment capability and is one of the more important indexes of long-term solvency. The cash flow figure in the numerator refers to net cash provided by operations as reported on the statement of cash flows in Figure 2. For small companies that don't prepare a cash flow statement, operating cash flow can be estimated by taking income before interest and taxes and adding back depreciation and other significant non-cash charges.

The industry average for this ratio is not likely to serve as a particularly useful benchmark. Bankers are more interested in the trend of the ratio. Increasing levels of debt without commensurate increases in cash generated by profitable operations is a sure sign on financial problems ahead. This could occur if the ROA is less than the borrowing rate.

K-L Fashions' earnings before interest and taxes is $259,610, compared with interest expense of $10,180. Thus, its interest coverage in terms of the times interest earned ratio is 25.5 times [$259,610 --.$10,180]. Although this ratio has declined substantially over the past three years, it has not declined as sharply as earnings because interest charges have declined. Furthermore, it is still quite large, indicating to creditors that interest payments are well covered.

K-L Fashions' cash flow statement shows that net cash provided by operations during fiscal year 1991 was $512,020, a substantial increase over both 1990 and 1989. Compared to the downward trend in net income, the cash flow from operations suggests the company has been reporting a large amount of noncash expenses like depreciation and amortization. A likely cause in the increased noncash charges is the large increases in land and buildings, and fixtures and equipment. Furthermore, it appears from the balance sheet that the expansion was financed by internally generated cash and without the assistance of long-term creditors. As these investments became productive, the company probably began depreciating them, resulting in the downward trend in net income. When these factors are considered, the decline in net profit margins does not look so serious.

The cash flow to total liabilities ratio [Operating Cash Flow / Total Liabilities] is therefore $512,020 / $685,740 = 74.7 percent. Standing alone, this ratio suggests that the company is conservatively capitalized and generates sufficient cash to cover its future obligations. The ratio is particularly healthy considering the fact that more than half of total debt is in the form of accounts payable, used to finance inventory and receivables.

Three Case Studies

Case 1: Is a critical supplier in good financial condition?

A manager should not overlook the use of financial statement data in selecting key suppliers of raw material and component parts if the information is available. For small companies that depend upon other companies for critical raw materials or merchandise, the ability to determine the availability of those items could mean the difference between success and failure. This is particularly important for the smaller companies that do not have the purchasing clout of their larger competitors. Yet this is one of the most overlooked aspects of inventory management in most companies.

One of the key criteria to consider in evaluating potential or existing suppliers is financial health. Unless a supplier has staying power, all of its other fine qualities won't mean much. Here we look to the supplier's financial statements for some answers. Four easily-obtainable ratios are probably sufficient to evaluate a supplier's financial health adequately: (1) profit margin, (2) inventory turnover, (3) quick ratio and (4) debt-to-equity.

The profit margin (return on sales) should be used in evaluating a supplier the same way was used to evaluate the manager's own company. It should be compared with other companies in the industry to evaluate the supplier's relative operating efficiency. More important, however, is to look at the trend of this ratio. Even if the current year's profit margin is within industry norms, a declining ratio could indicate that the supplier is facing serious competition or even a financial crisis.

The inventory turnover ratio can be used to determine whether the supplier's inventories are moving, on the one hand, and whether its inventory levels may be too low, on the other. A key is to consider the industry average. A low turnover could indicate that inventory is not moving, leading to a future liquidity crisis. An exceptionally high turnover could indicate that the supplier is maintaining very low inventory levels, which could mean that goods will not be available when a manager orders them.

The observation that high turnover could be either good or bad reinforces the point that ratio computation is the starting point for financial statement analysis - not the final point. Out-of-line ratios are "red flags" that call for an explanation. Any ratio that is too high or too low needs to be examined closely for its causes.

The quick and debt-to-equity ratios are used extensively by short-term creditors and long-term creditors, respectively, to assess a debtor's liquidity and debt structure. Although we are not concerned with being paid on time by the supplier, we want reasonable assurance that the supplier can discharge his financial obligations, both short-term as well as long-term, and will not be forced into bankruptcy. As noted earlier, the current ratio provides only a rough measure of the supplier's short-term debt paying ability. The quick ratio is a better test and usually is Just as easily obtainable from the supplier's balance sheet. Cash and cash equivalents (marketable securities), plus receivables, are frequently listed separately among the current assets. For this purpose, we would be satisfied with a quick ratio of 1.0 or higher, or at least equal to the industry norm.

The debt-to-equity ratio provides an indication of how heavily the supplier is in debt, relative to the amount of capital provided by the owners. The higher the ratio, the more concerned one should be about the long-term welfare of the supplier. As a customer, we probably wouldn't be too concerned as long as the supplier's D/E ratio is less than 100 percent, which would indicate equal amounts of debt and equity capital.

How would we assess K-L Fashions if it were a potential supplier of raw materials or component parts instead of a direct mail retailer? If we want to establish a relationship with this company and rely on it to make timely deliveries of critical items, we want to be sure it is in good financial condition. We have suggested four ratios that should be adequate for this purpose: the profit margin, inventory turnover, quick ratio and debt-to-equity ratio. Because we have calculated these ratios already, we will simply comment on them in the present context.

Recall that the profit margin was below average for the type of company involved and was declining. Looking at this measure alone, one might conclude that the supplier will soon be facing a serious financial crisis. However, the inventory turnover ratio was only slightly below the industry average and does not show a definite trend. Still, the inventory has been turning over only once every 80 days or so. This relatively low turnover ratio appears to be due primarily to a higher-than-average level of inventory as a percent of total assets. This could be viewed as favorable from our standpoint as customer, since high inventory levels should result in fewer back orders. However, high levels of slow moving inventories reduce the liquidity of a company's current assets and working capital.

The quick ratio of .5 times is substantially below the industry average - and the general benchmark - of 1.0 times. Since we are a customer in this case, we are not concerned about being paid by this company; but we might wonder about the company's ability to discharge its short-term debts as they come due. On the other hand, the debt-to-equity ratio of .6 times indicates that the company is not highly leveraged and still has a fair amount of financial flexibility. The company can probably obtain additional long-term funds to make up for near term shortfalls. So, while the first three ratios indicate that our potential supplier may be facing a liquidity squeeze, the last indicates that the company's total debt position is relatively solid. On balance, if this were one of a limited number of potential suppliers of critical materials, we would find little difficulty in establishing long-term commitments.

We based our evaluation of K-L Fashions solely upon information reported in its financial statements. Although we attempted to address the questions from the standpoint of an insider making a self-evaluation, we clearly do not have all of the specific knowledge that is available to management. Thus, while we might have expressed concern about the company's liquidity and profitability - particularly recent trends in these measures - it is possible that management has everything under control. The point of the illustration is that managers can use ratio and trend analysis to uncover danger signs and to point to areas that need attention.

Case 2: When sales decline, What can I do to weather the storm? Can I do anything to change it around?

For this case, there are two broad questions to examine:

(1) Looking back, did any of management's decisions cause the downturn?

(2) Looking forward, what can management do to get through the slump, and what can management do to reverse the slump?

In the previous case, financial statement analysis was used to answer a question and help make a decision. For this case, we use financial statement analysis to help manage the crisis, or point to sources for possible intervention.

What caused sales to go down? Obviously, external factors can cause sales slumps. However, it should be equally obvious that management's decisions can also affect sales. Where do these show up in financial statement analysis?

Sales returns - Although not discussed above, if sales returns as a percentage of sales increases, it could be a sign of poor product quality or general customer dissatisfaction. If product quality diminishes, you could be losing not just the current sales, but also sales well into the future. If you find that you are sending more raw materials or products back to your supplier, it could mean that too many inferior items are slipping through, and the quality of products you make or sell is suffering. Lost sales due to poor quality products can be very hard to turn around.

Net profit margin - While it's always nice to have a high net profit margin, a profit margin that grows too quickly could be a signal that some financial corners have been cut. For example, continuing with the sales return discussion, you could save money by buying cheaper goods. This would show up as a lower cost of goods sold, and a higher margin. However, cheaper goods could then result in dissatisfied customers and lost sales. You could also increase the profit margin by cutting advertising expense. This may also result in lower sales. Finally, a high profit margin could be a sign that prices are artificially high.

Accounts receivable turnover - It's nice to have a fast turnover of receivables. However, like the profit margin, a turnover ratio that changes too dramatically or too fast, could be a signal for lost sales. Potential sales could be lost if your sales instrument's credit and collection policy is too tight. For example, American Express requires the total balance on its charge cards to be paid upon receipt of the invoice. As a result of this policy, some customers prefer to pay with Visa, which allows periodic repayment, than with American Express. In American Express' case, their repayment policy might improve collections, but it also may result in lost sales.

Looking forward, what can management do to correct the declining sales pattern? Obviously, the first tack would be to fix any problems identified by the previous analysis. However, if this yields little help, there are other things management can do.

Accounts receivable turnover - Management might consider relaxing credit policies further, to generate more sales. This would cause the turnover to increase. With this policy, management runs the risk of giving the store away by selling to uncollectible accounts.

Inventory turnover - This is perhaps the most important ratio to monitor when sales decline. By effectively managing inventory levels, a manager can minimize the cost of lower sales. Because it costs money to buy and hold inventory, maintaining or increasing inventory turnover (by buying less and letting the stock run down) can save money and prevent losses.

Case 3: I can't pay my bills on time What should I do first?

As in Case 2, we can look to the financial statements for causes and cures. You may have a liquidity problem if the current and quick ratios are too low. The causes of cash flow problems include: declining sales, poorpricing, poor accounts receivable turnover and poor inventory turnover. Poor inventory turnover also means you are buying inventory, but that inventory isn't selling quickly enough.

Net profit margin - Looking at the net profit margin can give you insights on whether or not the product is priced adequately to cover overhead expenses. In the K-L Fashions case, sales were increasing, but the profit margin was decreasing. If the product is priced too low, then sales revenues may not be sufficient to cover all of the other operating expenses, like advertising, salaries, etc.

Inventory turnover - Even small changes in turnover ratios can have a significant impact on the earnings of a company. For example, in the K-L Fashions illustration, inventory turned over every 81.5 days. If K-L Fashions could reduce inventory and reduce turnover to the industry average of 72 days, then average inventory would decline to $704,825 [72 days * $3,573,070 (cost of goods)/365 days = $704,825] from $797,860. That amounts to $93,035 that could be invested elsewhere and save $9,304 in interest costs (using a 10 percent interest rate).

Accounts payable turnover - Similarly, the accounts payable turnover is presently 33 days. If K-L Fashions slows payment down by just one day, average accounts payable would rise to $321,799 [34 days * $3,454,610 (purchases)/365 = $321,799] from $311,060. The difference of $10,739 translates into a $1,074 interest savings.

To improve cash flow from receivables without adjusting your credit or collection policy, consider borrowing against the receivables through an assignment or factoring arrangement.

The Arkansas Small Business Development Center is funded in part through a cooperative agreement with the U.S. Small Business Administration through a partnership with the University of Arkansas at Little Rock College of Business and other institutions of higher education. All opinions, conclusions or recommendations expressed are those of the author(s) and do not necessarily reflect the views of the SBA. It is the goal of UALR to eliminate discriminatory harassment and to promote equal opportunity regardless of race, gender, color, national origin, sexual orientation, age, religion, veteran’s status, or disability.