Four key financial ratios to consider
In the current economic environment, firms are placing much more emphasis than ever before on financial integrity—the ability to survive an economic downturn with a minimum of pain. However, the vast majority of potential actions are ones that should have been taken before a recession hit. It proves almost impossible to strengthen balance sheets, for example, when sales and profits are sliding. In addition, some of the actions taken to strengthen the firm are proving to be counter-productive. For example, enhancing the firm’s cash position frequently comes at the expense of profitability.
Things To Do in the Future
There are a lot of ratios that firms should review to make sure they are prepared for economic challenges in the future. The four most important of these are reviewed in Exhibit 1. These include (1) Debt to Equity, (2) Defensive Interval, (3) Cash to Current Liabilities and (4) the Break-Even Point. These ratios were chosen because they are best suited to help the firm maintain a strong banking relationship, offset sales declines and position the firm for growth when economic conditions improve. The first column of numbers in Exhibit 1 presents suggestions for an appropriate result for each ratio. It should be noted that these guidelines are conservative. These are the results that will keep firms out of financial trouble except under the direst of economic conditions. The second column of numbers presents results for the typical MHEDA member based on the latest Distributor Performance Benchmarking Report. Column three is simply the difference between the first two columns and represents any potential gaps that must be closed.
Debt to Equity — This is the classic banker’s measurement of a firm’s financial philosophy. The lower the figure, the more conservative the firm. It is calculated by dividing total liabilities (all obligations of any kind, including accounts payable, notes payable and the like) by total equity (net worth). The historical banker’s goal for debt to equity is 1.0. In good economic times, firms tend to increase their debt-to-equity ratio in an effort to grow the business as fast as possible using outside financing. In bad times, firms tend to die in reverse debt-to-equity order. In the future, firms would be well-advised to maintain a 1.0 level and avoid the widely discussed “excessive exuberance.” This will most likely involve reinvesting a sizeable portion of future profits back into the business.
Defensive Interval — This is a classic little-used and little-understood ratio. It is calculated by dividing total operating expenses (excluding depreciation) by 365 to determine the cash expenses that must be met each day. This figure is then divided into cash to determine how many days the firm can operate if sales and collections fall all the way to zero. Clearly, this ratio measures a worst-case scenario. However, it provides some very strategic insights into the firm’s ability to withstand a sudden jolt in terms of sales and collections. Ideally, this ratio should be at least 15 days. The two alternatives to improve this result are to increase cash balances or to lower operating expenses, particularly payroll.
Cash to Current Liabilities — This is the most stringent test of the ability of the firm to meet its short-term obligations with existing cash balances. It is calculated by dividing cash by total current liabilities (largely accounts payable and short-term notes payable). This ratio examines how well the firm is able to continue to pay suppliers and other creditors (as opposed to operating expenses) without an additional infusion of cash. To be truly conservative with cash, this ratio should be around 20 percent. Again, there are two improvement paths—increase cash or lower short-term debt. One of the real mistakes that many firms made in the period of steady growth was to finance sales growth through short-term financing.
Break-Even Point —This is the level to which sales can drop before profit falls to zero. Since every MHEDA member has a different level of sales, this measure is presented as a percentage of current annual sales. Ideally, the break-even point should be no more than 80 percent of current sales. That is, the firm should be able to experience a 20 percent sales decline before profits are eliminated. Lowering the break-even point requires two parallel efforts. The first is to enhance the gross margin percentage so that the firm gets paid for what it does. The second is to gain tighter control over operating expenses.
Things Not To Do Now
Sadly, the list of things not to do is very similar to the list of things that most firms are currently doing. Of these, two are the most strategic.
Don’t Lower the Investment in Inventory and Accounts Receivable — Cash may be king, but converting inventory and accounts receivable to cash is not just a bad move, it is often a disastrous one. Lowering inventory almost always involves a “stop buying” edict. The firm immediately runs out of good inventory. Accounts receivable is often subject to a similar line of thinking. Lowering either of these will drive sales down even further.
Don’t Sell Out the Future — The break-even point needs to be lowered. However, anything that is associated with sales generation should be cut only if the situation is desperate. Too many firms reduce their marketing expenditures only to find that when the market begins to turn up, they have lost all of their visibility to potential customers. Cuts may be unavoidable, but they should be made only to the degree that is absolutely necessary for survival.
The good news is that the downturn will end, possibly even faster than most economists think. The bad news is that old habits die hard. Firms will forget about financial integrity in a bid for sales growth. When the next downturn comes, too many firms will inevitably repeat the mistakes of this one. It is a cycle that only enriches profitability/financial consultants, such as the author of this report. It is a cycle that must be broken.
Calculating the Break-Even Point
Break-even analysis is one of the most useful measurements that firms have in their financial tool kit. However, very few firms actually utilize the break-even point in their financial planning, largely because of uncertainty as to how it is calculated. The following example should assist in the calculation. All of the figures presented are for a typical MHEDA member currently generating $20 million in sales. As can be seen, the formula requires knowing only three things:
If the firm is unsure about the relative mix of fixed and variable expenses, a useful approximation is that about 80 percent of total expenses are fixed and everything else is variable. As long as the breakout is reasonable, the formula will provide an accurate answer. As shown, the typical MHEDA member, with current sales of $20 million has a break-even point of $4.4 million. This is equal to 89.8 percent of current sales, which means the firm can experience a sales decline of 10.2 percent before profits are eliminated.
|Meet the Author
Albert D. Bates, Ph.D., is founder and president of Profit Planning Group, a distribution research firm located in Boulder, Colorado, and on the Web at www.profitplanninggroup.com.