• Liquidity Ratios indicate a company's ability to pay its bills and overall cash availability.

a) Working Capital Ratio = Current assets divided by current liabilities
b) Quick Ratio = Cash plus accounts receivable divided by current liabilities
c) Cash Ratio = Cash and cash equivalents divided current liabilities

• Profitability Ratios indicate the level of profitability and return on investment in a business.

a) Net Profit Margin = Net income (after taxes) divided by sales
b) Return on Assets = Net income plus interest divided by average total assets. Average total assets equal assets at the beginning of the year, plus assets at the end of the year, divided by 2.
c) Return on Equity = Net income divided by average shareholders' equity. Average shareholders' equity equals shareholders' equity at the beginning of the year, plus shareholders' equity at the end of the year, divided by 2.

• Leverage Ratios indicate the debt structure of a business.

a) Long-Term Debt Ratio = Long-term debt divided by long-term debt plus shareholders' equity
b) Debt to Equity Ratio = Long-term debt divided by shareholders' equity
c) Total Debt Ratio = Total liabilities divided by total assets

• Efficiency and Turnover Ratios indicate a company's productivity and effective use of its assets.

a) Asset Turnover = Average sales divided by average total assets
b) Average Collection Period = Average receivables divided by average daily sales
c) Inventory Turnover = Cost of goods sold divided by average inventory

Break-even Analysis
The break-even point for a business is the point at which the contribution margin on a specific sales volume equals total fixed costs required to operate the business. It is the point at which neither a profit, nor a loss, occurs.

Every business must know its break-even point on a monthly and yearly basis to effectively manage cash flow and operations. The sales volume required for a business to break even is calculated by dividing its total fixed costs by the average contribution margin percentage received on its products and services.

More importantly, a "what if" analysis can be performed by varying fixed costs and/or contribution profit margin to determine the impact on the company's break-even point. For example, if fixed costs increase and the contribution margin remains constant, then sales volume required to break even will increase.

Businesses that are considering moving to a more expensive facility, adding administrative staff or expecting increases in any of their fixed expenses, must perform this analysis to determine the additional sales volume required to cover the increased costs and maintain their break-even point. As a rule of thumb, each time you are considering increasing the fixed costs in your business, ask yourself, "What is the increased sales dollars I must get from customers to afford this increase? And, can I realistically get customers to buy this much more?"

Leverage Analysis
Leverage calculations are performed to determine to what degree a business is using debt and fixed costs to enhance its operations. A business may be leveraged in two ways: financially, when debt is used to expand and operate the business, or operationally, when fixed costs (e.g., facilities and equipment) are added to achieve higher sales volumes.

• Financial Leverage = Operating margin (before interest) divided by profit margin before income taxes

The higher the ratio, the more financially leveraged a business is said to be. The "right" level of financial leverage is dependent on the growth potential in the markets a business serves. It might be quite appropriate to "leverage" a business, if the market served is growing and capital is needed to be able to participate and profit from this market growth.
 

• Operational Leverage = Contribution margin divided by operating margin

Note that the difference between a company's contribution margin and its operating margin is fixed costs. And, when fixed costs increase without an increase in contribution margin, then operational leverage also increases.

Calculating and monitoring both financial and operational leverage over time will help any business reach an appropriate level of debt and spending on fixed costs, which is required for the business to grow and achieve higher profitability.

Basic Financial Tools
Understanding and utilizing the basic financial tools, along with the financial statements discussed in the September issue, can enhance a small business' ability to improve sales, profitability, efficiency and competitive advantage.

Phil Watlington teaches finance, managerial accounting and strategic planning through the University of Phoenix and is a senior manager at the General Electric Company. He is the author of The World Is At Your Door. You can reach him at (913) 485-2577, or