Business Ratios and Formulas E-Book

Steven M. Bragg

• Herausgeber: John Wiley & Sons
• Kategorie: Fachliteratur
• Serie: Wiley Corporate F&A
• Sprache: Englisch

Seitenzahl: 608

Veröffentlichungsjahr: 2012

Beschreibung

A complete appraisal of analytical tools available to managers to assess performance Required reading for anyone starting, running, or growing a business, Business Ratios and Formulas, Third Edition puts answers at the fingertips of business managers, with nearly 250 operational criteria and clear, easy-to-understand explanations that can be used right away. The Third Edition includes twenty new measurements. * Approximately 20 new measurements * Offers a comprehensive resource of nearly 250 operational criteria * An Appendix including a dictionary of accounting and finance terms * A thorough list of every ratio and formula, and how to compile and interpret that information * Also by Steven M. Bragg: Fast Close: A Guide to Closing the Books Quickly, Second Edition An ideal tool for measuring corporate performance, this authoritative resource allows you to pick and choose the tools you need to best assess your organization's performance.

Leseprobe

Contents

Cover

Series

Title Page

Copyright

Dedication

Preface

Acknowledgments

CHAPTER ONE: Introduction

CHAPTER TWO: Asset Utilization Measurements

SALES TO WORKING CAPITAL RATIO

SALES TO FIXED ASSETS RATIO

SALES TO ADMINISTRATIVE EXPENSES RATIO

SALES TO EQUITY RATIO

SALES PER PERSON

SALES BACKLOG RATIO

SALES RETURNS TO GROSS SALES RATIO

REPAIRS AND MAINTENANCE EXPENSE TO FIXED ASSETS RATIO

ACCUMULATED DEPRECIATION TO FIXED ASSETS RATIO

CAPITAL TO LABOR RATIO

FRINGE BENEFITS TO WAGES AND SALARIES EXPENSE

SALES EXPENSES TO SALES RATIO

DISCRETIONARY COST RATIO

INTEREST EXPENSE TO DEBT RATIO

FOREIGN EXCHANGE RATIOS

OVERHEAD RATE

GOODWILL TO ASSETS RATIO

OVERHEAD TO COST OF SALES RATIO

INVESTMENT TURNOVER

BREAK-EVEN POINT

MARGIN OF SAFETY

TAX RATE PERCENTAGE

CHAPTER THREE: Operating Performance Measurements

OPERATING ASSETS RATIO

SALES TO OPERATING INCOME RATIO

SALES MARGIN

GROSS PROFIT PERCENTAGE

GROSS PROFIT INDEX

INVESTMENT INCOME PERCENTAGE

OPERATING PROFIT PERCENTAGE

OPERATING LEVERAGE RATIO

NET INCOME PERCENTAGE

CORE OPERATING EARNINGS

PROFIT PER CUSTOMER VISIT

PROFIT PER PERSON

CORE GROWTH RATE

QUALITY OF EARNINGS RATIO

CHAPTER FOUR: Cash Flow Measurements

CASH FLOW FROM OPERATIONS

FREE CASH FLOW

CASH FLOW RETURN ON SALES

FIXED CHARGE COVERAGE

EXPENSE COVERAGE DAYS

CASH FLOW COVERAGE RATIO

CASH RECEIPTS TO BILLED SALES AND PROGRESS PAYMENTS

CASH TO CURRENT ASSETS RATIO

CASH FLOW TO FIXED ASSET REQUIREMENTS

CASH FLOW RETURN ON ASSETS

CASH TO WORKING CAPITAL RATIO

CASH REINVESTMENT RATIO

CASH TO CURRENT LIABILITIES RATIO

CASH FLOW TO DEBT RATIO

REINVESTMENT RATE

STOCK PRICE TO CASH FLOW RATIO

DIVIDEND PAYOUT RATIO

CHAPTER FIVE: Liquidity Measurements

ACCOUNTS RECEIVABLE TURNOVER

AVERAGE RECEIVABLE COLLECTION PERIOD

DAYS DELINQUENT SALES OUTSTANDING

DAYS SALES IN RECEIVABLES INDEX

ACCOUNTS RECEIVABLE INVESTMENT

ENDING RECEIVABLE BALANCE

INVENTORY TO SALES RATIO

INVENTORY TURNOVER

INVENTORY TO WORKING CAPITAL RATIO

LIQUIDITY INDEX

ACCOUNTS PAYABLE DAYS

ACCOUNTS PAYABLE TURNOVER

CURRENT RATIO

QUICK RATIO

CASH RATIO

SALES TO CURRENT ASSETS RATIO

WORKING CAPITAL PRODUCTIVITY

DAYS OF WORKING CAPITAL

WEIGHTED WORKING CAPITAL

DEFENSIVE INTERVAL RATIO

CURRENT LIABILITY RATIO

REQUIRED CURRENT LIABILITIES TO TOTAL CURRENT LIABILITIES RATIO

WORKING CAPITAL TO DEBT RATIO

RISKY ASSET CONVERSION RATIO

NONCURRENT ASSETS TO NONCURRENT LIABILITIES RATIO

SHORT-TERM DEBT TO LONG-TERM DEBT RATIO

ALTMAN'S Z-SCORE BANKRUPTCY PREDICTION FORMULA

CHAPTER SIX: Capital Structure and Solvency Measurements

TIMES INTEREST EARNED

CASH COVERAGE RATIO

DEBT COVERAGE RATIO

ASSET QUALITY INDEX

ACCRUALS TO ASSETS RATIO

TIMES PREFERRED DIVIDEND EARNED

DEBT TO EQUITY RATIO

FUNDED CAPITAL RATIO

RETAINED EARNINGS TO STOCKHOLDERS' EQUITY

PREFERRED STOCK TO TOTAL STOCKHOLDERS' EQUITY

ISSUED SHARES TO AUTHORIZED SHARES

CHAPTER SEVEN: Return on Investment Measurements

NET WORTH

BOOK VALUE PER SHARE

TANGIBLE BOOK VALUE

RETURN ON ASSETS EMPLOYED

RETURN ON INFRASTRUCTURE EMPLOYED

RETURN ON OPERATING ASSETS

RETURN ON EQUITY PERCENTAGE

RETURN ON COMMON EQUITY

FINANCIAL LEVERAGE INDEX

EQUITY GROWTH RATE

EARNINGS PER SHARE

PERCENTAGE CHANGE IN EARNINGS PER SHARE

ECONOMIC VALUE ADDED

EVA MOMENTUM

RELATIVE VALUE OF GROWTH

DIVIDEND PAYOUT RATIO

DIVIDEND YIELD RATIO

CHAPTER EIGHT: Market Performance Measurements

INSIDER STOCK BUY-SELL RATIO

INSTITUTIONAL CAPTURE RATE

MARKET VALUE ADDED

ENTERPRISE VALUE/EARNINGS RATIO

STOCK OPTIONS TO COMMON SHARES RATIO

COST OF CAPITAL

SALES TO STOCK PRICE RATIO

PRICE/EARNINGS RATIO

CAPITALIZATION RATE

CHAPTER NINE: Measurements for the Accounting/Finance Department

PURCHASE DISCOUNTS TAKEN TO TOTAL DISCOUNTS

PERCENTAGE OF PAYMENT DISCOUNTS MISSED

TRANSACTIONS PROCESSED PER PERSON

TRANSACTION ERROR RATE

AVERAGE TIME TO ISSUE INVOICES

AVERAGE EMPLOYEE EXPENSE REPORT TURNAROUND TIME

PAYROLL TRANSACTION FEES PER EMPLOYEE

TIME TO PRODUCE FINANCIAL STATEMENTS

PERCENTAGE OF TAX FILING DATES MISSED

PROPORTION OF PRODUCTS COSTED PRIOR TO RELEASE

INTERNAL AUDIT SAVINGS TO COST PERCENTAGE

INTERNAL AUDIT EFFICIENCY

DEDUCTION TURNOVER

BAD DEBT PERCENTAGE

PERCENT OF RECEIVABLES OVER XX DAYS OLD

ALLOWANCE EXHAUSTION RATE

PERCENTAGE COLLECTED OF DOLLAR VOLUME ASSIGNED

CASH COLLECTED PER AGING BUCKET

COLLECTION EFFECTIVENESS INDEX

BEST POSSIBLE DSO

PARTIAL PAYMENT AGREEMENT PERCENTAGE

PERCENT OF CASH APPLIED ON DAY OF RECEIPT

AUTO CASH HIT RATE

UNMATCHED RECEIPTS EXPOSURE

COST OF CREDIT

EARNINGS RATE ON INVESTED FUNDS

BROKERAGE FEE PERCENTAGE

BORROWING BASE USAGE PERCENTAGE

CHAPTER TEN: Measurements for the Engineering Department

BILL OF MATERIALS ACCURACY

LABOR ROUTING ACCURACY

IDEA KILL RATE

PERCENTAGE OF NEW PRODUCTS INTRODUCED

PERCENTAGE OF SALES FROM NEW PRODUCTS

PERCENTAGE OF NEW PARTS USED IN NEW PRODUCTS

PERCENTAGE OF EXISTING PARTS REUSED IN NEW PRODUCTS

AVERAGE NUMBER OF DISTINCT PRODUCTS PER DESIGN PLATFORM

PERCENTAGE OF PRODUCTS REACHING MARKET BEFORE COMPETITION

RETURN ON INNOVATION INVESTMENT

INTANGIBILITY INDEX

SCIENCE LINKAGE INDEX

RATIO OF ACTUAL TO TARGET COST

WARRANTY CLAIMS PERCENTAGE

TIME FROM DESIGN INCEPTION TO PRODUCTION

PERCENTAGE OF FLOOR SPACE UTILIZATION

CHAPTER ELEVEN: Measurements for the Human Resources Department

EMPLOYEE TURNOVER

AVERAGE TIME TO HIRE

LATE PERSONNEL REQUISITIONS RATIO

SENDOUTS PER HIRE

INTERN HIRING PERCENTAGE

RATIO OF SUPPORT STAFF TO TOTAL STAFF

EMPLOYMENT COST EFFECTIVENESS

CHAPTER TWELVE: Measurements for the Logistics Department

PRODUCTION SCHEDULE ACCURACY

ECONOMIC ORDER QUANTITY

NUMBER OF ORDERS TO PLACE IN A PERIOD

ECONOMIC PRODUCTION RUN SIZE

RAW MATERIAL INVENTORY TURNS

RAW MATERIAL CONTENT

FINISHED GOODS INVENTORY TURNS

OBSOLETE INVENTORY PERCENTAGE

PERCENTAGE OF INVENTORY > XX DAYS OLD

PERCENTAGE OF RETURNABLE INVENTORY

EXCESS INVENTORY INDEX

INVENTORY ACCURACY

PERCENTAGE OF CERTIFIED SUPPLIERS

ELECTRONIC DATA INTERCHANGE SUPPLIER PERCENTAGE

DISTRIBUTION TURNOVER

SUPPLIER FILL RATE

ON-TIME PARTS DELIVERY PERCENTAGE

PURCHASED COMPONENT DEFECT RATE

INCOMING COMPONENTS CORRECT QUANTITY PERCENTAGE

PERCENTAGE OF ACTUAL PAYMENTS VARYING FROM PURCHASE ORDER PRICE

PERCENTAGE OF PURCHASE ORDERS ISSUED BELOW MINIMUM DOLLAR LEVEL

PROPORTION OF CORPORATE CREDIT CARD USAGE

PERCENTAGE OF RECEIPTS AUTHORIZED BY PURCHASE ORDERS

FREIGHT AUDIT RECOVERY RATIO

PICKING ACCURACY FOR ASSEMBLED PRODUCTS

ORDER FILL RATE

AVERAGE TIME TO SHIP

ON-TIME DELIVERY PERCENTAGE

DOCK-TO-DOCK TIME

PERCENTAGE OF PRODUCTS DAMAGED IN TRANSIT

PERCENTAGE OF SALES THROUGH DISTRIBUTORS

CHAPTER THIRTEEN: Measurements for the Production Department

CONSTRAINT PRODUCTIVITY

TAKT TIME

CONSTRAINT REWORK PERCENTAGE

CONSTRAINT SCHEDULE ATTAINMENT

CONSTRAINT UTILIZATION

OPERATIONAL EQUIPMENT EFFECTIVENESS

DEGREE OF UNBALANCE

THROUGHPUT EFFECTIVENESS

MANUFACTURING CRITICAL PATH TIME

MANUFACTURING EFFICIENCY

BREAK-EVEN PLANT CAPACITY

MANUFACTURING EFFECTIVENESS

PRODUCTIVITY INDEX

UNIT OUTPUT PER DIRECT LABOR HOUR

AVERAGE EQUIPMENT SETUP TIME

UNSCHEDULED MACHINE DOWNTIME PERCENTAGE

MEAN TIME BETWEEN FAILURES

ACCEPTABLE PRODUCT COMPLETION PERCENTAGE

WORK-IN-PROCESS TURNOVER

WORK-IN-PROCESS TO STANDARD WORK-IN-PROCESS

SCRAP PERCENTAGE

FIRST-TIME-THROUGH YIELD

WARRANTY CLAIMS PERCENTAGE

MAINTENANCE EXPENSE TO FIXED ASSETS RATIO

INDIRECT EXPENSE INDEX

REORDER POINT

ON-TIME DELIVERY RATIO

CHAPTER FOURTEEN: Measurements for the Sales and Marketing Department

MARKET SHARE

CUSTOMER TURNOVER

ADVERTISING VALUE EQUIVALENCY

NET PROMOTER SCORE

BROWSE-TO-BUY CONVERSION RATIO

RECENCY

DIRECT MAIL EFFECTIVENESS RATIO

INBOUND TELEMARKETING RETENTION RATIO

PROPORTION OF COMPLETED SALES TO HOME PAGE VIEWS

QUOTE TO CLOSE RATIO

PULL-THROUGH RATE

SALES PER SALESPERSON

SALES PRODUCTIVITY

SALES EFFECTIVENESS

SALES TREND PERCENTAGE BY PRODUCT LINE

PRODUCT DEMAND ELASTICITY

DAYS OF BACKLOG

CHAPTER FIFTEEN: Measurement Analysis with an Electronic Spreadsheet*

FINANCIAL STATEMENT PROPORTIONAL ANALYSIS

FINANCIAL STATEMENT RATIO ANALYSIS

AUTOMATED RATIO RESULT ANALYSIS

LEVERAGE ANALYSIS

TREND ANALYSIS

FORECASTING

CASH FLOW ANALYSIS

CAPITAL ASSET ANALYSIS

COMPOUNDING ANALYSIS

INVESTMENT ANALYSIS

RISK ANALYSIS

Appendix: Measurement Summary

Glossary

About the Author

Index

Founded in 1807, John Wiley & Sons is the oldest independent publishing company in the United States. With offices in North America, Europe, Asia, and Australia, Wiley is globally committed to developing and marketing print and electronic products and services for our customers' professional and personal knowledge and understanding.

The Wiley Corporate F&A series provides information, tools, and insights to corporate professionals responsible for issues affecting the profitability of their companies, from accounting and finance to internal controls and performance management.

Copyright © 2012 by John Wiley & Sons, Inc. All rights reserved.

Published by John Wiley & Sons, Inc., Hoboken, New Jersey. Published simultaneously in Canada.

Previous Edition: Business Ratios and Formulas: A Comprehensive Guide, Second Edition. ISBN-13: 978-0-470-05517-5. Published by John Wiley & Sons, Inc. Copyright © 2007.

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Library of Congress Cataloging-in-Publication Data:

Bragg, Steven M. Business ratios and formulas : a comprehensive guide / Steven M. Bragg. – 3rd ed. p. cm. – (Wiley corporate F&A series) Includes index. ISBN 978-1-118-16996-4 (hardback); ISBN 978-1-118-22683-4 (ebk); ISBN 978-1-118-23982-7 (ebk); ISBN 978-1-118-26442-3 (ebk) 1. Business mathematics. I. Title. HF5691.B73 2012 650.01'513–dc23 2011042682

To Andrea and Victoria

The value of watching you grow has been beyond measurement.

Preface

THIS BOOK IS INTENDED for all corporate managers who need to understand the performance levels of their departments. It contains performance measurements for the accounting, engineering, logistics, production, and sales departments. These measurements cover not only financial matters, but also those related to efficiency, effectiveness, capacity, and market share. In addition, the book includes measurements related to asset utilization, operating performance, cash flows, liquidity, capital structure, return on investment, and market performance. These latter categories are of great interest not only to the accounting and finance departments, but also to a company's creditors and investors.

There are nearly 250 measurements itemized in this book. Each one is accompanied by a complete description, an explanation of the calculation, an example, and cautions regarding its use. The cautions are of particular use, as they describe the elements of a measurement that can be modified to deliver misleading results, different measurements that may work better in certain situations, use on a trend-line basis, and other measurements that should be used to reinforce indicated results.

The book also describes how to use an electronic spreadsheet to compile a standard set of measurements, using Microsoft Excel as the template. This is especially useful for investors and financial personnel who need to compile information about a company's long-term performance.

Anyone who wishes to create a complete set of performance-tracking measurements for an entire company or for a specific function can use this book as a reference source. Managers can choose the correct blend of measurements to achieve an information set that can be used for feedback on strategy initiatives and specific efficiency projects, as well as for performance evaluations. This is the ideal tool for measuring corporate performance.

Centennial, Colorado March 2012

Acknowledgments

TO SHECK CHO, the editor I have known longer than anyone else in the publishing business. Sheck, I value your experience and advice—you are the best.

CHAPTER ONE

Introduction

EVERY DEPARTMENT IN EVERY business produces some kind of information that can be used by its manager to measure performance. This information may be related to operational considerations within the department, the financial condition of the entire company, or the performance of a company's suppliers and customers. Unfortunately, managers may not be aware of the multitude of measurements that can be used to track these different levels of performance or of the ways that these measurements can yield incorrect or misleading information.

This book is intended to help managers select the best possible set of measurements for a given situation. Chapters 2 through 14 itemize a series of performance measurements for different aspects of a company. Chapter 2 contains asset utilization measurements that can be used to determine a company's ability to sustain its sales, the level of asset and expense usage required to do so, and the sustainability of its current sales and expense levels. There are also specialized ratios that deal with such issues as sales returns, repairs and maintenance, fringe benefits, interest expense, and overhead rates.

Chapter 3 contains operating performance measurements, which describe an organization's operating performance in such areas as sales, gross margins, investment income, operating profit, and net profit.

Chapter 4 contains cash flow measurements, which are useful in determining the ability of a company's cash flows to keep it in business. These measurements should be used in conjunction with the liquidity measurements in Chapter 5, which focus on additional measurements related to cash flows, such as a company's ability to collect accounts receivable in an efficient manner, use its inventory within a short time, pay its accounts payable when due, and generally maintain a sufficient amount of liquid funds to pay off short-term liabilities. Chapter 6 contains capital structure and solvency measurements, which determine the relationship between a company's debt and equity, as well as the comparative proportions of different types of stock. It also addresses a company's ability to remain solvent and so can be used in conjunction with Chapters 4 and 5.

Chapter 7 contains return on investment measurements, which encompass net worth, several types of return on assets and equity, earnings per share, economic value added, and return on dividends. Chapter 8 addresses a company's financial market performance by describing such measurements as the price/earnings ratio, several variations on the stock options to common shares ratio, market value added, and the cost of capital.

Chapters 9 through 14 cover measurements for individual departments. These chapters are devoted to performance measurements for the accounting, engineering, human resources, logistics, production, and sales departments. In contrast to Chapters 2 through 8, which are devoted to measurements that are primarily used by the accounting and finance functions, Chapters 9 through 12 are more concerned with such issues as work capacity levels, efficiency, and effectiveness, which in many cases require no financial information at all. For example, measurements in Chapter 12, which deals with logistics, cover such topics as production schedule accuracy, on-time parts delivery percentage, and picking accuracy for assembled products.

Chapter 15 covers a variety of topics related to measurements using the Microsoft Excel electronic spreadsheet, including how to set up comprehensive sets of measurements that can be used for proportional, leverage, ratio, and trend analyses. It also covers a variety of spreadsheet formulas and report formats for forecasting, cash flow analysis, capital asset purchase analysis, interest compounding, investment analysis, and risk analysis.

The book concludes with an appendix and glossary. The appendix lists the names and formulations of every measure in the book, sorted by chapter. This list should only be used with the precautions given for them in their respective chapters to ensure their proper use. The glossary covers the definitions of the terms found in many of the measurements listed in this book, to clarify the exact types of information needed.

The chapters containing measurements (Chapters 2 through 14) are all structured identically. Each begins with a table that lists the measurements described in it, which one can use to quickly access a needed calculation. Thereafter, each chapter is broken down into the discussions of individual measurements. Within each measurement section there is a description, formula, example, and discussion of cautionary items. The description typically notes how the measurement is used and who uses it. The formula shows any variations on the calculation and what types of data to include or exclude from it. The example is generally a complete scenario that describes how the measurement is used in a simulated business situation. Finally, any cautionary items are noted; these can include the ways in which the measurement can be altered to yield incorrect results, or what other measurement should be used with it in order to yield a more comprehensive set of information.

The reader may use this book to search for a single calculation, which can be used for highly targeted needs. However, a better approach is to peruse the entire book, with the objective of developing a complete set of measurements that will yield a more comprehensive view of a company's entire operating and financial situation. For example, a CFO might be interested in a company's stock market performance and therefore watch only the price/earnings ratio. This single measurement, however, focuses only on the perception of investors with regard to a company's future earnings potential. A more rounded set of measurements might include the days of sales backlog (since it indicates future changes in sales volume), production capacity utilization (since it shows the ability of the company to produce its incoming sales), and the days of accounts receivable (since it shows the company's ability to convert sales into cash). The exact set of measurements will change in accordance with a company's industry, size, operational configuration, and degree of financial leverage, but one issue will remain the same: A single measurement is not enough to yield a clear view of a company's financial and operating condition.

Many of the ratios in this book are of the nonfinancial variety, such as mean time between failures, the science linkage index, and the quote to close ratio. Managers have a difficult time creating a linkage between these nonfinancial measures and improvement. A common result is for managers to impose a broad range of nonfinancial measurements upon a company, hoping that some behavior changes will result in improved financial performance. A better approach is to conduct a detailed review of the financial performance drivers of a business, and to only measure the results of nonfinancial measurements that are likely to have a direct impact on those financial measures. For example, a consulting business is experiencing significant delays in the completion of customer projects, which delays revenue generation; the delays are caused by a high level of employee turnover, requiring long lead times to bring in qualified replacement staff. Thus, a reasonable nonfinancial measurement in this case is the annual employee turnover percentage, since there is a direct linkage between it and revenue generation.

Once nonfinancial measurements are selected, be sure to verify that improvements in the activities being measured are actually resulting in altered financial performance. There is often merely an assumption that enhancements to a nonfinancial activity will improve financial performance, but no one has actually tested the assumption. This verification step will ensure that measures that do not assist in improving financial results are thrown out.

A major problem with measurement systems is inconsistency of application. If a company has multiple locations, then it must have a system in place for ensuring that the same measure is calculated in exactly the same way in every location. Local managers can be quite skilled at tweaking measurement systems to reveal the best possible results, frequently by excluding some data from measurements, altering the date ranges over which data is collected, or altering the measurements themselves. This issue can be monitored through the use of occasional internal audits, or with centralized measurement systems that keep local managers from being involved in the measurement process.

Even if a company has developed a reasonable set of measurements, this does not mean that they should never be changed. On the contrary, measured items will generally garner a great deal of management attention and then improve to the point at which they no longer change—thereby resulting in a stale set of measurements. For example, inventory accuracy can improve only to 100%. At that point, the measurement is needed on a monitoring basis to ensure that it does not degrade, while a new measurement can be created to be the focus of corporate attention. However, there will be a few measurements, usually involving sales levels and break-even points, that will always be the centerpiece of any measurement system, since they bring attention to bear on the most crucial revenue and cost elements of the business. Thus, a properly designed measurement system should include a few key items that will be constant for many years, accompanied by other measures that are used for internal improvement purposes and will change in concert with corporate objectives.

A final warning: Do not become so enamored of measurement systems that you burden the company with a wild profusion of measurements that track every conceivable activity, since this causes several problems. First, no one knows which of the measures are most useful for tracking the company's ability to achieve its mission. Therefore, they try to perform well under all of the measures, resulting in resources being allocated to the improvement of some measures that have no bearing on financial performance. Second, employees may engage in irrational behavior in order to achieve high scores through the measurement system, even if they must downgrade their performance in areas not being measured.

This book is filled with almost 250 financial and operational measurements that have proven to be of considerable use to the author in tracking the performance of many companies in a variety of industries. If you would like to see other measurements in the next edition of this book, please send your request to the author at [email protected].

CHAPTER TWO

Asset Utilization Measurements

THIS CHAPTER FOCUSES ON the ratios and formulas that can be derived primarily from the income statement. There are several that require additional information from the balance sheet, as well as internal information, such as employee headcount, that may not be readily discernible from published financial statements. The general intent of the analysis tools presented here is to show a company's ability to sustain its sales, the level of asset and expense usage required to do so, and the sustainability of its current sales and expense levels. There are also specialized ratios that deal with such issues as sales returns, repairs and maintenance, fringe benefits, interest expense, and overhead rates.

Each of the following sections describes the uses of a ratio or formula, explains the proper method of calculation, and gives an example. Each section also discusses how each ratio or formula can be misused, skewed, or incorrectly applied.

The ratios and formulas presented in this chapter are:

Sales to Working Capital Ratio Sales to Fixed Assets Ratio Sales to Administrative Expenses Ratio Sales to Equity Ratio Sales per Person Sales Backlog Ratio Sales Returns to Gross Sales Ratio Repairs and Maintenance Expense to Fixed Assets Ratio Accumulated Depreciation to Fixed Assets Ratio Capital to Labor RatioFringe Benefits to Wages and Salaries Expense Sales Expenses to Sales Ratio Discretionary Cost Ratio Interest Expense to Debt Ratio Foreign Exchange Ratios Overhead Rate Goodwill to Assets Ratio Overhead to Cost of Sales Ratio Investment Turnover Break-Even Point Margin of Safety Tax Rate Percentage

SALES TO WORKING CAPITAL RATIO

Description: It is exceedingly important to keep the amount of cash used by an organization at a minimum, so that its financing needs are reduced. One of the best ways to determine changes in the overall use of cash over time is the ratio of sales to working capital. This ratio shows the amount of cash required to maintain a certain level of sales. It is most effective when tracked on a trend line, so that management can see if there is a long-term change in the amount of cash required by the business for it to generate the same amount of sales. For instance, if a company has elected to increase its sales to less creditworthy customers, it is likely that they will pay more slowly than regular customers, thereby increasing the company's investment in accounts receivable. Similarly, if the management team decides to increase the speed of order fulfillment by increasing the amount of inventory for certain items, then the inventory investment will increase. In both cases, the ratio of working capital to sales will worsen because of specific management decisions. This ratio is also used for budgeting purposes, since budgeted working capital levels can be compared to the historical amount of this ratio to see if the budgeted working capital level is sufficient.

Formula: Annualized net sales are compared to working capital, which is accounts receivable, plus inventory, minus accounts payable. One should not use annualized gross sales in the calculation, since this would include in the sales figure the amount of any sales that have already been returned and are therefore already included in the inventory figure. The formula is:

Example: The Jolt Power Supply Company has elected to reduce the amount of inventory it carries for some of its least-ordered stock items, with the goal of increasing inventory turnover from twice a year to four times a year. It achieves its inventory goal rapidly by selling back some of its inventory to its suppliers in exchange for credits against future purchases. Portions of its operating results for the first four quarters after this decision was made are shown in Table 2.1.

TABLE 2.1

The ratio calculation at the end of each quarter is for annualized sales, so we multiply each quarterly sales figure by 4 to arrive at estimated annual sales. The accounts receivable turn over at a rate of once every 30 days, which does not change through the term of the analysis. Inventory drops in the second quarter to arrive at the new inventory turnover goal, while the amount of accounts payable stays at one-half of the revenue level, reflecting a typical distributor's gross margin of 50% throughout all four periods. The resulting ratio shows that the company has indeed improved its ratio of working capital to sales, but at the price of some lost sales to customers who were apparently coming to the company because of its broad inventory selection.

Cautions: As stated in Table 2.1, using this ratio to manage a business can yield unforeseen results, such as a drop in sales because of reduced inventory levels or tighter customer credit controls. Also, arbitrarily lengthening the terms of accounts payable for the purpose of reducing the working capital investment will likely lead to strained supplier relations, which may eventually result in increased supplier prices or the use of different and less reliable suppliers.

SALES TO FIXED ASSETS RATIO

Description: In some industries, a key barrier to entry is the large amount of assets required to produce revenues. For example, the oil-refining business requires the construction of a complete refining facility before any sales can be generated. By using the sales to fixed assets ratio, one can see if a company is investing a great deal of money in assets in order to generate sales. This is a particularly effective measure when compared to the same ratio for other companies in the same industry; that is, if another company has found a way to generate profitable sales with a smaller asset investment, then it will be rewarded with a higher valuation. This measure is also useful when tracked on a trend line, so that one can see if there are any sudden jumps in asset investments that the company has made to incrementally bring in more sales. For example, a printing facility may have achieved 100% utilization of its printing plant, and so cannot generate more sales without a multimillion-dollar investment in new equipment. In such cases, the key question is whether there is a reasonable expectation of generating a sufficient incremental increase in revenues to justify the additional investment.

Formula: Divide net sales for a full year by the total amount of fixed assets. There are several variations on this formula. One is to calculate annualized net sales on a rolling basis, so that the last 12 months of revenue are always used. This can be a better approach than attempting to extrapolate revenues forward for several months, especially if future revenues are uncertain. The denominator in the calculation, which is the amount of total fixed assets, may be used net of depreciation or before depreciation; the most common usage is after depreciation, since this is more indicative of the actual value of the assets. However, if accelerated depreciation is used, there may be little relationship between the amount of depreciation recognized and the value of the fixed assets, which may lead one to use total fixed assets before accumulated depreciation. Both variations on the formula are shown here:

Example: The Turtle Tank Company creates tracked vehicles for a number of military organizations. It has recently received an order from the country of Montrachet for annual delivery of 20 tanks per year for the next eight years. The trouble with this order is that the company's existing capacity can handle only 10 more tanks per year. An entire additional production line must be created for it to manufacture the extra tanks, which will require an increase in fixed assets of $20 million. The price the company will receive for each tank is $850,000. It currently produces 70 tanks per year, and has fixed assets of $40 million. Based on these numbers, its net sales to fixed assets ratio will change, as shown in Table 2.2.

TABLE 2.2

If No ChangeIf Invest in New LineAnnual sales$68,000,000$76,500,000Total fixed assets$40,000,000$60,000,000Sales to fixed assets ratio1.7:11.3:1

The Turtle Tank Company is a publicly held company, so its management is concerned that the much lower ratio that would be caused by the new investment would not compare favorably to the same ratio for its competitors. This might cause investors to think that the company is poorly managed, resulting in a sell-off of its stock. An alternative solution for the situation is for the managers to ignore the short-term impact of the ratio and instead to focus on the key issue, which is whether there will be enough additional business in the future to justify the additional investment.

Cautions: The sales to fixed assets ratio should not be used at a consolidated level for companies that include many types of businesses, since it is quite possible that only a few businesses within the entity are asset-intensive. For this reason, it is better to calculate the measure for individual businesses or product lines. The ratio can also be misleading if a company does not have sufficient funds to purchase new assets, in which case it may appear to have a small asset base due to the large amount of offsetting depreciation expense that has accumulated over time.

SALES TO ADMINISTRATIVE EXPENSES RATIO

Description: A key issue is how much overhead expense is needed to maintain a certain level of sales volume. For example, a company with a strategy of selling very small orders to its customers requires a large accounting department, not only to issue a vast quantity of invoices, but also to process a large number of payments. Similarly, if a company has a large proportion of employees to the amount of revenue generated (such as a restaurant chain), then the human resources staff will be correspondingly large. In these cases, it is important to ensure that the administrative expense is carefully controlled so that it does not have an excessively large impact on profits.

Formula: Divide annualized net sales by the total of all general and administrative expenses. It is better to use the last 12 months of net sales for the annualized net sales figure, rather than an estimate of sales for future months, since the look-forward estimate may be substantially incorrect. Also, the expense figure in the denominator should include the cost of the sales department, especially if its cost is largely fixed (as is the case when the sales staff has a high proportion of salaries to commissions). The formula is:

Example: The Windy Weather Gauge Company has experienced a sharp drop in sales volume. Its ratio of sales to general and administrative expenses has changed from 1:0.1 to 1:0.2, indicating that this cluster of expenses has doubled in proportion to overall sales. This relative expense increase will certainly have a major negative impact on profits. The controller needs to see if it is possible to drop these expenses back to their previous proportion to sales. Finding that the primary expense in this area is salaries, the controller quickly determines that there are so few personnel in each of the administrative areas that only outsourcing or the merging of departments will allow the company to achieve its previous sales to administrative expenses ratio. Accordingly, the human resources work is taken on by the controller, computer systems development is curtailed, and the accounting department combines its accounts payable and receivable staff into a single group. Thus, quick action based on this ratio allows the company to shrink its administrative expenses down to a level that will ensure continuing profits.

Cautions: This ratio can be used as the justification for a reduction or freeze in the amount of general and administrative expenses, on the grounds that the proportion of expenses to sales in the past should be the same in the future. However, if there is a significant change in sales volume, this is a less clear relationship. For example, if sales volume doubles, it is quite possible that the general and administrative expense does not have to double as well, since much of the existing infrastructure may be able to handle the additional growth. Conversely, a significant drop in sales volume may still require a company to leave much of its general and administrative expenses in place because of long-term contracts that cannot be voided (such as building leases) or the presence of significant fixed assets (such as computer centers) that cannot be reduced to reflect the smaller sales volume. Consequently, changes to general and administrative expenses may be indicated by this ratio, but in-depth analysis must be done to determine if a change is really possible.

SALES TO EQUITY RATIO

Description: This ratio is used to determine the amount of equity that should be retained within a business as sales volumes fluctuate. For example, if sales growth increases rapidly, it is likely that a considerable additional amount of working capital will be required to sustain this higher level of sales growth. If so, the required cash can come from debt, internal cash generation, or equity. The ratio can also be used to determine if too much equity has accumulated in a business, so that some may be extracted through extra dividends, a stock buyback, or some other form of distribution.

Formula: Divide annual net sales by total equity. It is important to include retained earnings in the denominator; many companies that have high margins or have been generating profits for many years have accumulated a great deal of retained earnings, which may make up the largest component of equity. The formula is:

Example: An examiner for the Friendly Tax Collection Service calls on a company that has paid out no dividends for the past few years. An examination of the company's accounting records reveals the information shown in Table 2.3.

TABLE 2.3

This table reveals that the company is extremely profitable, with over a million dollars being added to retained earnings in every year. The company does not appear to be using these funds, since the amount of incremental investment in fixed assets is minuscule. The sales to equity ratio shows that the amount of equity in the business is continuing to rise in relation to sales. Consequently, the auditor can make a good case that the company should be distributing more of its equity as dividends; being taxable, these dividends will increase the taxes collected by the Friendly Tax Collection Service.

Cautions: If a company is already highly leveraged, the amount of equity is so small that the sales to equity ratio has no particular relevance. Also, a decision to shift away from debt to more equity, or vice versa, will have a significant impact on this ratio even if there is no change in the sales level. A company's financing decisions consequently have a great deal of influence over this ratio.

SALES PER PERSON

Description: This is one of the most closely watched of all performance measures. It is based on the assumption that employees are at the core of a company's profitability, and so high degrees of efficiency in this area are bound to result in strong profitability. It is also a standard benchmark in many industries.

Formula: Divide revenue for a full year by the total number of full-time equivalents (FTEs) in the company. An FTE is the combination of staffing that equals a 40-hour week. For example, two half-time employees would be counted as one FTE. The formula is:

A variation on this ratio is to divide annual revenues by only those FTEs that can be categorized as direct labor. This measures the productivity of those personnel who are directly connected to the manufacture of a company's products or services. This measure should be used with care, since it is not always easy to determine which employees can be categorized as direct labor and which ones fall into the overhead category instead. The formula is:

Example: The operations manager of the Twirling Washing Machine Company wants to determine the sales per person for the company, both for all staff and just the direct labor personnel. The company has annual revenues of $4.2 million. Its headcount is as follows:

DepartmentHeadcountDirect labor department22Direct labor part-time staff6Production supervisors2Materials-handling department4Sales, general and administrative10Administrative part-time staff2Engineering department8

The company has 54 employees. However, if the part-time staff all work half-time, then the eight part-time positions can be reduced to four FTEs, which decreases the total headcount to 50 personnel. Another issue is what constitutes direct labor personnel—the company has a group of clearly defined direct labor personnel, as well as a materials-handling support staff and two production supervisors. The company can use any combination of these groups for its sales per direct labor measurement as long as it consistently applies the measurement over time. The technically correct approach, however, is to include in the measure any positions that are required for the proper completion of production efforts, which would require the inclusion of all three categories of labor. If this approach were not used, the person doing the measuring might be tempted to artificially inflate the measurement results by shifting direct labor personnel into other labor categories that fall just outside the definition.

The result of these measurements is overall sales per employee of $84,000 (which is $4,200,000 in revenues, divided by 50 employees) and sales per direct labor employee of $135,484 (which is $4,200,000 in revenues, divided by 31 employees). The employee figure of 31 was derived by adding 22 direct labor personnel to the three FTEs represented by the six part-time direct labor personnel, plus the production supervisors and materials-handling staff.

Cautions: This formula is subject to a high degree of variation, depending on how personnel are counted. For example, shifting away from employees to an outsourced solution or to the in-house use of temporary employees can artificially reduce the number of FTEs, as can the use of overtime by a smaller number of employees. Also, comparing the number of FTEs to revenue has less direct bearing on profitability than comparing revenues to the total of all salaries and wages expenses; for example, one company with a large headcount but low pay per person may be more profitable than a company having a lower headcount but a much higher salary per person. Also, some capital-intensive industries have so few employees in relation to the sales volume generated that this measure has much less significance than other measures, such as sales to fixed assets.

SALES BACKLOG RATIO

Description: The sales backlog ratio cannot be determined strictly from any standard financial statements, since the backlog is normally included only in internal management reports. Nonetheless, if the backlog information is available, this ratio should be an extremely useful tool for determining a company's ability to maintain its current level of production. If the ratio is dropping rapidly over several consecutive months, then it is likely that the company will soon experience a reduction in sales volume as well as over-capacity in its production and related overhead areas, resulting in imminent losses. Conversely, a rapid jump in the ratio indicates that a company cannot keep up with demand, and it may soon have customer relations problems from delayed orders and need additional capital expenditures and staff hirings to increase its productive capacity.

Formula: Divide the most current total backlog of sales orders by sales. It is generally best not to use annualized sales in the denominator, since sales may vary considerably over that period, due to the influence of seasonality. A better denominator is sales over just the preceding quarter. The formula is:

A variation on this formula is to determine the number of days of sales contained within the backlog, which is achieved by comparing the backlog to the average daily sales volume that a company typically produces. This formula is:

Example: The sales and backlog data for the Jabber Phone Company are shown in Table 2.4.

TABLE 2.4

This table reveals that the company's sales are continuing to increase over time, while its backlog is decreasing. The change was caused by an increase in the company's productive capacity for additional cell phones. As a result, the company is gradually clearing out its backlog and converting it into sales. However, the management team must be aware that, if the present trend continues, the company will eventually clear out its entire backlog and find itself with a sudden reduction in sales, unless it greatly increases its sales and marketing efforts to build the backlog back up to a higher level.

Cautions: The sales backlog ratio is less useful for businesses that are oriented toward a just-in-time manufacturing model, since these organizations tend to operate with a reduced backlog. It is also of limited use for highly seasonal businesses, since their intention is to completely clear out their backlogs at the end of the selling season and then build up inventory for the next selling season, even in the absence of a backlog.

SALES RETURNS TO GROSS SALES RATIO

Description: This ratio reveals the extent of returns on its sales. An excessive level of returns can be indicative of product flaws requiring replacement, or an overly generous returns policy, or the sudden appearance of a competing product on the market that distributors would rather keep in stock. No matter what the cause, this ratio is a good initial indicator of an underlying problem related to the product, prices, or market.

Formula: Divide total sales returns by gross sales. This ratio can be unusually high or low from month to month, because sales returns are usually related to shipments made in previous months; consequently, a high sales month may have very low associated sales returns, which instead will appear in the ratio for the following month. To avoid this problem, the ratio should be aggregated on a rolling quarterly basis, so that returns will be more likely to be matched against related sales. The formula is:

Example: The Matterhorn Pen Company sells the bulk of its pens during the Christmas selling season, with a sharp drop in sales immediately thereafter. Table 2.5 shows the sales and return figures for the six months nearest the Christmas season.

TABLE 2.5

This table shows that there is a time lag of exactly one month on all sales returns, and that the return rate is always exactly 10% when compared to the gross sales from which the returns originated. Because of the extreme seasonality of sales, however, the returns ratio varies enormously from period to period, with the worst case being in January, when the returns from the massive December sales month are offset against the puny January postseason sales. To fix this problem, the controller elects to measure the ratio on a rolling three-month basis, which smoothes out the ratio somewhat, as shown in Table 2.6. However, the returns attributable to the December sales month occur in January, which therefore still appear in the March three-month rolling measurement when the corresponding sales have dropped out. To avoid this problem, reporting the measure could be delayed by one month on an ongoing basis so that the most recent month's returns could be divided by the sales from the preceding month.

TABLE 2.6

Cautions: The amount of sales returns can be masked, rendering this ratio less informative. For example, a company can offer free extra products or services to a customer who wishes to make a return rather than accepting the returned goods. Another ploy is to charge off to expense an unreasonably high or low return reserve or to roll returns into some other account. Also, unusual returns, such as products that are being called back to the factory to repair a serious flaw, may be recorded against a special loss reserve. Another variation is to shift returned goods back into finished goods inventory and then write up the value of this inventory without ever making a charge against sales. By any or all of these means, a company can hide the true amount of its sales returns.

REPAIRS AND MAINTENANCE EXPENSE TO FIXED ASSETS RATIO

Description: This ratio is useful for estimating the age of the collective group of fixed assets listed in the financial statements. If the ratio follows an increasing trend line, then the company is probably in need of some asset replacements. An increasing trend line may also be indicative of high asset-usage levels, which can prematurely require advanced levels of repair work. Of particular interest is an increasing ratio that suddenly drops with no corresponding increase in the amount of fixed assets. This indicates that a company is running out of cash and cannot afford to repair its existing assets or purchase new ones.

Formula: Divide the total amount of repairs and maintenance expense by the total amount of fixed assets. If the expense is broken down into subcategories, such as between production equipment and facilities, then the measure can be calculated for each category presented. It is better to calculate the ratio with the total amount of fixed assets in the denominator, rather than net of depreciation, since the type of accelerated depreciation method would otherwise affect the amount of net assets used in the calculation. The formula is:

Example: The Hot Cinnamon Candy Company is being examined by the due diligence team of another candy company, which may decide to make an acquisition offer. The due diligence team has collected information about the company, as shown in Table 2.7.

TABLE 2.7

This table shows the impending demise of the candy company—sales are dropping, which may be the cause of a continuing decline in available cash and an increase in the amount of debt. Of particular concern is the sudden drop in the amount of repairs expense in Year 4, because there is no corresponding increase in the fixed assets account that would indicate that new assets have been purchased. The due diligence team should conclude that a purchase of this company would require a cash infusion to fix a backlog of equipment repairs.

Cautions: As noted earlier, the ratio can be manipulated by company management if it chooses to delay making expenditures on needed asset repairs. Also, a high ratio can yield misleading conclusions, because it can indicate that management is taking the best possible care of its equipment or that the equipment is so old that it is near the point of failure. Also, the amount of repairs and maintenance expense can be manipulated by shifting the salaries of the equipment repair staff to some other overhead category or by outsourcing the work. Finally, this ratio may not change much from period to period in those situations in which a company employs a repair team whose wages will be charged to the repairs account at all times, even if there are no repairs to be made.

ACCUMULATED DEPRECIATION TO FIXED ASSETS RATIO

Description: Comparing the amount of accumulated depreciation to the gross amount of fixed assets recorded on a company's balance sheet can indicate the extent to which a company has continued to replace its existing assets with new ones on an ongoing basis. For example, if the proportion of accumulated depreciation to fixed assets is quite high, it is evidence that not too many assets have been added by a company in recent years, which may in turn lead one to suspect that there is little cash available for such investments.

Formula: Divide the total accumulated depreciation by the total amount of fixed assets. A variation on this approach is to run the same calculation for different classes of assets to see whether there are certain types of assets in which a company does not appear to be making a sufficient level of investment in new assets. The formula is:

Example: A potential acquirer is reviewing the financial statements of the Bavarian Clock Company. The financial information under review is limited and does not contain a sufficient degree of information regarding cash flows from year to year. Consequently, the acquirer is trying to get a general idea of the company's ability to generate cash by reviewing the expenditures it has made for fixed assets. The assumption is that an increase in the ratio of accumulated depreciation to fixed assets over time is an indicator of a shortage in cash. The financial information is compiled in Table 2.8.

TABLE 2.8

The ratio at the bottom of the table indicates that the company appears to have experienced a sudden drop in its cash flow in the past two years because the amount of accumulated depreciation has skyrocketed in comparison to the fixed asset base, indicating that the company has stopped purchasing fixed assets.

Cautions: This ratio can present an incorrectly unfavorable view of a company's reinvestment policy if the company has taken an aggressive approach to depreciation, using accelerated depreciation calculations and short estimated time periods over which assets are depreciated. Under this treatment, depreciation levels will rise rapidly, leading one to believe that a company's asset base is older than it really is. Also, a company owning long-term assets that require minimal replacement will also show a high ratio of accumulated depreciation to fixed assets, even though there is no particular need to buy new equipment. In this case, one should look at the amount of repairs and maintenance expense to see if a proper level of expenditures is being made to keep the equipment operational. Finally, a company's accounting staff may not be making journal entries that would eliminate from the balance sheet the asset cost and accumulated depreciation associated with assets that are no longer on the premises. If so, the volume of accumulated depreciation listed in the balance sheet may appear to be quite high; this is evidence less of improper asset management and more of inadequate accounting for eliminated assets.

CAPITAL TO LABOR RATIO

Description: There is a general tendency among businesses to invest more in capital assets if they have a high cost of labor on the grounds that it is less expensive to automate certain tasks than to pay wages for the same tasks. Conversely, there is a tendency not to invest in capital assets when the cost of labor is low, since it is not cost-effective to do so. The capital to labor ratio calculates this proportion. It is most useful to do so over a lengthy time, to see whether there is a trend in one direction or the other. An increasing proportion can signal that the total cost of labor has risen so much that management is seeking to use automation to remain competitive in its market.

Formula: Divide the book value of all tangible fixed assets by the fully burdened cost of labor. Book value is the original cost of a fixed asset minus the accumulated depreciation associated with it. The fully burdened cost of labor includes base compensation, bonuses, the company-paid portion of payroll taxes, and employee benefits. The formula is:

Example: Sniper Inc. manufactures high-end hunting rifles for the consumer market as well as sniper rifles for the military. Its workforce has traditionally been a group of highly trained and highly paid craftsmen. The workforce was unionized several years ago, and the union has pushed for substantially greater employee benefits. As a result, management has gradually invested in more automated equipment on the shop floor. The capital to labor trend shown in Table 2.9 demonstrates this change, where the investment in fixed assets has driven a reduction in total employee compensation.

TABLE 2.9

5 Years AgoTodayBook value of tangible assets$20,000,000$36,000,000Total employee compensation$42,000,000$38,500,000Capital to labor ratio48%94%

Cautions: The capital to labor ratio is best used only to demonstrate long-term changes in the structure of a business. Incremental changes in the ratio on a month-to-month basis will likely be so minor as to not be worth consideration. The ratio can be skewed if a business uses accelerated depreciation, since that artificially reduces the book value in the numerator of the formula. Also, the outsourcing of work to a third party will artificially reduce the amount of employee compensation in the denominator, which skews the results of the formula.

FRINGE BENEFITS TO WAGES AND SALARIES EXPENSE

Description: Apparently small changes in a company's benefit policies can have a profound impact on the total benefits expense for a company. The best way to see the total impact of these changes is to calculate a ratio of fringe benefit costs to total wages and salaries. This is also a useful measure when comparing the overall fringe benefit costs of two companies that are considering merging, so that the surviving entity can calculate the potential savings to be made by shifting the other company's benefit plan to that of the acquirer. This can also be a tool for comparing the benefit costs of union shops to non-union shops, since there can be significant differences in the benefits granted to union members.

Formula: Add together the cost of all discretionary benefit costs, minus the cost of any related deductions from employee pay, and divide this amount by the total of all wages, salaries, and payroll taxes. The formula is as follows:

Example: The Associated Grocers Corporation (AGC) is considering a hostile takeover of the Federated Grocers Corporation (FGC). It needs to find ways to cut expenses after the acquisition in order to prove to its shareholders that the transaction is cost-effective. One area under consideration is the fringe benefits of FGC. Since this is a hostile takeover attempt, FGC is not cooperating in providing detailed benefits information to AGC. Instead, AGC can obtain the fringe benefits and wages information of FGC from publicly available sources. The AGC acquisition team prepared Table 2.10.

TABLE 2.10

AGC (Acquirer)FGC (Acquiree)Total fringe benefits$1,490,000$1,420,000Total wages and salaries$7,842,000$5,917,000Fringe benefits to wages ratio19%24%Potential savings—$296,000

The table reveals that, though the total dollars associated with fringe benefits for both companies are nearly the same, the proportion of fringe benefits to wages and salaries for the acquiree are 5% higher than for AGC. By reducing this percentage to 19% (the same one achieved by AGC), the acquirer can reasonably estimate that a savings of $296,000 can be achieved by using its benefits package at the acquiree.

Cautions: The ratio can be rendered incorrect if the denominator includes one-time costs associated with severance packages or hiring bonuses. Also, unusual one-time benefits, such as Christmas bonuses, can cause unusual spikes in the ratio in the months when these benefits are paid out; this problem can be resolved later by accruing for one-time benefits over all months, thereby smoothing out their impact.

SALES EXPENSES TO SALES RATIO

Description: The type of sales method used to bring in sales may be so expensive that the margin obtained from any sales does not even cover the cost of sales. This ratio is useful for determining the variable cost of sales, so that management can determine whether the sales system must be altered to result in a less expensive approach.

Formula: Divide all sales-related costs by total sales. Since sales expenses incurred may not result in sales for several months, it is best to calculate this ratio on at least a quarterly basis. The formula can also be broken down into smaller pieces, so that, for example, sales compensation is compared only to sales. The basic formula is:

Example: The Moving Cart Corporation (MCC) manufactures food carts for street vendors. Since rolling out a line of partially customized food carts, its profits have dropped. Further investigation reveals the information in Table 2.11.

TABLE 2.11

Before Custom CartsAfter Custom CartsSales$4,500,000$7,500,000Gross margin$1,800,000$2,925,000Gross margin percentage40%39%Sales salaries$240,000$400,000Sales travel costs$15,000$285,000Other operating expenses$1,395,000$2,325,000Net margin+$150,000–$85,000Sales expense to sales5.7%9.1%

The table reveals that MCC has achieved approximately the same proportion of gross margin and operating expenses to sales through the transition to custom carts, but that its sales costs (especially its travel costs) have risen considerably. A change in the sales method, from traveling to customer locations to some less personalized approach, is clearly in order.

Cautions: There may be an exceedingly long time lag between the incurrence of sales expenses and any resulting sales, such as when sales cycles are long (e.g., government sales) or when products must be hand-built for customers over a long time (e.g., passenger ships). This may render the ratio difficult to use as a comparative tool.

DISCRETIONARY COST RATIO

Description: This ratio is extremely important when reviewing companies that are locked into tight cash flow situations, because an analyst can use it to determine what costs can be dispensed with in the short term to bring a company back to a neutral or positive cash flow situation. A high ratio of discretionary costs to sales means that there are considerable opportunities for expense reductions.

Formula: Divide all discretionary costs by sales. Discretionary costs can include marketing, research and development, training, and repairs and maintenance costs, as well as any other costs that do not directly contribute to ongoing sales or production activities.

Example: The management team of the Tony Twinkle Donut Company wants to take its company private. To do so, the team has obtained a great deal of debt financing, which must be paid off by cutting deeply into the company's discretionary costs. To see if this option will work, the chief financial officer has constructed the list of discretionary costs shown in Table 2.12.

TABLE 2.12

Discretionary CostsRepairs and maintenance$185,000Marketing$486,000Training$72,000New product development$340,000Total$1,083,000

In addition to the $1,083,000 of discretionary costs, the company already generates $650,000 of cash flow, for a total available cash flow of $1,733,000 if all discretionary costs are not incurred.

The total amount of debt required to take the company private is $15,000,000 and carries an interest rate of 9.75%. The incremental tax rate is 34%. Based on this information, the company can pay the interest on the loan, which costs $965,250 after taxes ($15,000,000 × 9.75% × (1 – 34%)), but will only have $767,750 of funds available to pay off the principal on the debt each year. The management team decides that it is too risky to withhold these discretionary costs for the many years required to pay off the debt, and withdraws its buyout offer from consideration by the board of directors.

Cautions: This ratio is only useful for short-term measures, since discretionary costs cannot be delayed forever. For example, the complete elimination of all marketing costs will eventually destroy a company's market share, while delayed repair costs will cut into the useful productive capacity of the manufacturing department and may take some equipment completely out of action. Consequently, this ratio should only be used for short-term corporate turnarounds for which funds are expected to be available at a later date.

INTEREST EXPENSE TO DEBT RATIO

Description: This ratio is useful for determining the approximate interest rate that a company is paying on its debt. An analyst can use this information to see whether a company is paying unusually high interest, which can be indicative of financial difficulties that are leading lenders to charge inordinately high rates of interest.

Formula: