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Financial Analysis Using Ratios FAQs
Summary: Frequently-asked questions about performing financial analysis using Clients & Profits. Because Clients & Profits is a complete accounting system, it helps you quickly analyze the financial performance of your shop. The basis of financial analysis is to use the costs, billings, and overhead expenses everyone enters into Clients & Profits to identify potential problems. This analysis also shows you whether your finances are on track and 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 shop. 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.
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. You can use the financial ratios for different accounting periods to evaluate the company's performance over time. Also, you can use your numbers to compare against 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, that is, your G/L accounts have accurate balances. Make sure you've at least completed all the recommended monthly procedures in C&P. Ideally, also audit your key accounts looking for human error causing incorrect G/L balances. 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 help manage cash flow?
Liquidity ratios measure the ability of a company to pay its bills. Generally, the higher the ratio, the more solvent the company.
Working Capital (a.k.a. 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 in the short run. 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. Less than 1, the company may need to draw on a line of credit or request a capital contribution to pay it's short term debt.
Q. What best measures the agency's ability to generate earnings?
The income statement and profitability ratios. The income statement is the most useful financial analysis tool. Percentage income statements, like the ones in Clients & Profits, are especially helpful when compared to other fiscal periods or information from other agencies. Both gross profit and net income are reported on the income statement. The gross profit margin is the total revenue less job costs. The net income is the total revenue less all expenses (job costs and overhead). The percentages are derived by dividing the actual dollar amount by the total revenue.
Revenue, job cost, and expense account balances are also expressed as a percentage of total revenue. However, you can choose to print percentages based on a divisor of total revenue (standard) or of gross profit (AGI). Select the Show AGI checkbox to change the divisor for the percentages to the gross profit margin. Compare month-to-date percentages on the income statement to year-to-date percentages on the same statement. If any of the percentages vary, it's a flag that there's a change in the company's finances that should be understood. Compare them to prior years using the comparative income statement to see if financial performance has improved or worsened. 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) a.k.a. Return on Assets = Net Income After Taxes/Total Assets - Shows how efficiently assets are being used. ROI compares the company's total assets (investment) to the net income. If the company has a high asset value, but a weak net income, the owners aren't getting a high return on their investment.
Return on Equity (ROE) = Net Income After Taxes/Equity. The ROE compares what the owners have tied up in the company to the net income for a ratio that's similar to ROI.
Q. What are good measures of billing activity and client payments?
The client aging is the most important tool an agency has for checking the speed of invoice payments. This report is easily printed from the Snapshots menu. The aging shows at a glance which client accounts are overdue.
The liquidity ratio which measure the speed at which accounts are converted into cash is:
Average Days in A/R = 30 days/Accounts Receivable Turnover. The A/R Turnover is a calculation of the total billings for an accounting period divided by the average A/R account balance for that period. The average days in A/R can be derived manually using a second method where you divide the average billings per day for a period into the average A/R account balance for that period. Determine the average billings per day by dividing total billings 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 and adjust the calculation using 365 days. Both methods should return the same average days an A/R invoice is on the aging.
Q. What are good measures of debt?
Use debt ratios (solvency ratios in C&P) 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 that the agency is using more financial leverage -- a greater amount of other people's money is being used to generate profits. The CFO needs to decide if the company's cash flow can support these principal and interest payments.
Debt Ratio = Total Liabilities/Total Assets. The debt ratio measures the proportion of total assets financed by creditors. A ratio greater than one indicates there could be future solvency issues.
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. Sometimes, all liabilities, not just long-term debt, is used in this calculation. Taking on debt can be advantageous if the increase in earnings generated by this debt is more than the debt's interest expense (assuming the agency's cash flow can cover the debt service during the life of the debt).
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