Using income statement ratio analysis to stay on track

Savvy entrepreneurs track how their businesses are progressing by doing ratio analysis each month. Examining several key ratios on your income statement will reveal whether your business is in good shape or headed for a cash crunch.

Using your income statement data to figure your accounts receivable, accounts payable, and inventory ratios will tell you how fast you are having to pay suppliers, getting paid by customers, and moving products off the shelves. (If you sell services instead of goods, the inventory calculation won't apply.)

Accounts Receivable Turnover

To figure accounts receivable turnover, look at a year's worth of past monthly statements and add up the daily amount of accounts receivables (unpaid customer bills). Divide by 365 to get your average daily receivables. Next add up the total amount of sales you made that year on credit to get your total annual credit sales. Now you can figure your accounts receivable turnover rate:
Accounts receivable turnover = average daily receivables x 365 / total annual credit sales

For example, if your daily average is $25,000 and the total you sold on credit for the year was $200,000, you're taking 45.6 days to collect on an average bill. If your terms are net 30 days, slow payers are choking off your cash flow.

Accounts Payable Turnover

Next compare this figure with your accounts payable turnover rate: how quickly you pay suppliers. Ideally this figure is larger than the accounts receivable turnover rate.

To figure your payables turnover ratio, first add up your payables for each day of a year and divide by 365 to get your average daily payables. Then add up how much you bought on credit for the year to get your total credit purchases. Now you're ready to do the accounts payable turnover ratio formula:

Accounts payable turnover = average daily payables x 365 / total annual credit purchases

If your average payables are $8,000 and you purchase $98,000 in goods on credit in a year, your ratio is 29.8 days. This means you pay suppliers in just less than 30 days. Since customers aren't paying you for more than 45 days, you likely have a cash-flow problem because you need to cover the gap between when you pay for the item and when you collect the customer's payment.

Inventory Turns

The next key ratio is inventory turns. How long do products sit on your shelves before they're sold? Here's the formula:

Inventory turns = average daily inventory x 365 / total annual cost of goods sold

If you have $45,000 of average daily inventory on hand and your total annual cost of goods is $120,000, it's taking an average of 136.8 days for an item to be sold.

Now we have the story of your business: You buy an item, and on day 29 you pay for it. Then on day 137, a customer buys it on credit, taking 45 more days to pay for it. That means from the day you buy an item, it takes 182 days for you to get paid, leaving a 153-day gap during which your business has to finance that purchase. That's an important fact to know when you're figuring whether you are really selling goods at a profit because you need to include the finance cost of any borrowing needed to stay afloat.

Tracking these three ratios each month will show whether your business metrics are improving or deteriorating. Other ratios you can calculate to track important trends in your business include gross margin and net profit.

To make the most of ratio analysis, obtain industry average ratios or ideal targets to compare with your own ratios. Your industry association may have some helpful data, or tap business networking groups to find chatty colleagues with similar businesses.  

US-based business reporter Carol Tice contributes to several national and regional business publications.

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