Strategic Alignment of Information Technologies – Part 3

The Income Statement

A company’s income statement[1] is a financial report that tells us what transpired over a range of dates that led to either profit or loss for the organization. Just like we have laid out balance sheet numbers side-by-side for easy comparison, we can do the same thing with income statement figures, as well.
By looking at ABC Widgets Manufacturing’s Income Statements spreadsheet, one might immediately note that year 2004 was a very good year for the company. The firm made PBIT (profit before income taxes) of $126,000 on sales of $8.1 million. Revenues for 2004 were nearly $850,000 more than the average in years 2005 through 2008.
Of course, one cannot help but notice that NPAT (Net Profits after Taxes) declined dramatically between 2004 and 2007, where it reached its nadir of only $2,000. Things were not much better in 2008 where it rebounded to only $9,000 on more than $7 million in revenues.
Once again, these are interesting observations, but it is still hard to tell – at a glance – the management implications of some of these numbers. What might help us would be looking at some of the working relationships (ratios) between various numbers supplied to us from this historical data.

Ratio Analysis

Ratio analysis allows us to look at a set of calculated values – calculated from the underlying data we have just reviewed – in order to assess more quickly our organization’s positions and trends relative to

1. Solvency
2. Safety
3. Working Capital
4. Profitability
5. Asset Management

Solvency Ratios

Current Ratio = Current Assets / Current Liabilities  Interpretation: Higher is better

This ratio simply tells you, at a glance, how many dollars your organization has available in “current assets” to meet the demands of “current liabilities.” As we can see, in 2004, ABC Widgets had a little over $2 ($2.05) in current assets to satisfy every dollar in current liabilities. However, by 2008, that number had dwindled to only $1.35 to cover every dollar in current liabilities.

Quick Ratio or “Acid Test” Ratio = (Cash + AR + Marketable Securities[2]) / Current Liabilities  Interpretation: Higher is better

The Quick Ratio is referred to as the “acid test” of solvency because it looks only to the firm’s most liquid assets to meet the requirements of current liabilities. In 2004 our sample company had nearly 80 cents to satisfy every dollar in current liabilities. By 2005 that number had fallen to only about 50 cents for every dollar in current liabilities and has remained almost unchanged since.

Safety Ratio

Debt-Equity Ratio = Total Liabilities / Equity  Interpretation: Lower is better

The intent of this metric is to indicate the ability of the firm to withstand adversity (from a financial perspective only, of course). It may be understood as the “risk” metric, so the higher the value, the higher the risk. Over the five years we are considering here, this firm allowed its Debt-Equity (D-E) ratio to drift well above 1.30 at times, but has recovered to the present 1.37. The “1.37” means that the firm owes $1.37 for every dollar it has in equity. Therefore, in the midst of adversity, even if the company could not meet its obligations from current assets, the firm’s equity could likely step up to help meet the challenges.

Working Capital

Working Capital = Current Assets – Current Liabilities  Interpretation: Lower is better
Working Capital is the spread (in dollars) between current assets and current liabilities. It measures how many dollars the firm has tied up in its supply chain. In general, it is better to reduce this number. Organizations with higher cash velocities tend to have less cash tied up in their supply chain.[3]
Cash Conversion Cycle = Inventory Days + AR Avg. Days – AP Avg. Days  Interpretation: Lower is better
An organization’s Cash Conversion Cycle measures how long – how many days – cash is tied up in the supply chain on average. Again, fewer days in a firm’s Cash Conversion Cycle is better because it is indicative of one or more of the following:

• More rapid inventory turnover
• Improved AR average days-to-pay
• Faster payment of AP vendors[4]

[To be continued]
©2010 Richard D. Cushing

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[1] Sometimes referred to as a “Profit and Loss Statement”
[2] In our examples, the firms have no marketable securities.
[3] Some speed-demon companies even manage to have “negative” Working Capital through special supply chain arrangements.
[4] Only vendors that supply inventory or other product-related services should be included in calculating AP Average Days to Pay.