Business Management Articles
5 Ratios can Provide Recession Protection
Christopher Porter,
Plant
April 2009
It’s amazing how quickly things can change. Only a year ago, the Canadian dollar was higher than the US greenback. Stock markets were soaring. The economy was growing.
A year later, manufacturers and exporters are doing business quite differently. Coping with the ups and downs of today’s markets requires adjustments to focus and strategies. Close monitoring of financials, for example, is now essential in order to flag emerging issues and address them on a timely basis.
Financial projections are among the most important tools to guide a company through difficult times. By forecasting a company’s future financial situation, a management team can anticipate potential problems and plan appropriate solutions. Projections should include a balance sheet, statement of operations and a cash flow statement, by month for one year and by quarter for the subsequent two years. It’s helpful to develop best and worst-case scenarios to anticipate potential problem areas.
Building key ratios into these projection models can equip management with a broad and deep early warning system. Reviewing projections and ratios at least monthly, and ideally weekly, will alert the management team to trends, including whether cash flow, operating credit lines or margins are tightening and whether loan covenants are under stress.
Following are five ratios that can help to protect your operation from an unforeseen liquidity catastrophe.
1. Gross Margin
Many manufacturers have had to deal with rising costs for inputs and pricing pressures as a result of a falling dollar and supplies sourced outside of Canada. Analyzing gross profit margin (total sales revenue – cost of goods sold / total sales revenue x 100) can help to determine the degree to which an enterprise is able to efficiently use raw materials, labour and fixed assets to generate profits.
Monitoring by product line is beneficial for pinpointing problem areas and enabling management to make timely costing and pricing decisions. Analysis of the components of the margin can assist in identifying whether problems are related to direct labour, materials, overhead, foreign exchange or other issues.
To improve gross margins, some companies utilize forward contracts when sourcing materials to limit downside cost exposure and to set costs and pricing in tandem. For companies that have sound relationships with suppliers, it may be possible to negotiate more flexible terms or discounts. When it comes to controlling direct labour costs, reviewing production schedules can lead to opportunities to reduce overtime and unnecessary additional costs.
2. Break even Analysis
Breakeven analyses (breakeven point = fixed costs/ (unit selling price – variable costs)) enable a management team to monitor fixed costs, variable costs and returns in order to determine minimum sales levels and optimal selling prices. With an in-depth understanding of fixed and variable costs, management can respond promptly to changes in prices or revenues and focus on the best ways to reduce costs or increase sales.
Conducting breakeven analyses by division or product line can yield helpful information to point out the micro indicators impacting the business. Management may, for example, be able to identify whether rising overhead may necessitate consolidation of production facilities, or whether increasing labour costs may require revising production schedules or increasing the number of shifts.
3. Days Sales in Accounts Receivable
Days sales in accounts receivable (Accounts receivable / (sales/365)) identifies the number of days worth of sales a company has not yet collected. During a downturn, it is especially important to know how quickly the customer base is remitting payments. A ratio that is rising rapidly can indicate that accounts receivable are becoming riskier.
Calculating the days sales in accounts receivable (also known as average collection period or collection ratio) every month enables management to determine whether customer payments are trending downward and provides an opportunity to investigate why these changes are happening. Is an increase in the number of days sales caused by a few customers? A specific geographic customer base? A certain product line? It’s also helpful to know the average collection period for your industry and to compare this with your company’s results on a regular basis.
Management may have to spend more time working with customers, especially those feeling the effects of the recession and experiencing similar accounts receivable challenges. They may need to contact certain customers to identify specific issues, to review credit policies and terms or to expedite the collection of accounts receivable.
4. Days cost of sales in inventory
The days cost of sales in inventory ratio (average inventory / (annual cost of goods sold / 365)) estimates the number of days of cost of sales that a company has in its inventory levels. A management team can more effectively manage inventory and cash flow by building this ratio into forecasts and monitoring it on a monthly basis. Ideally, customer demand should be closely balanced with supply orders to maintain stable cash flow.
Looking for trends is the most important aspect of managing this ratio (also known as days of sales in inventory). An overinvestment in inventory can be costly, tying up essential working capital. An increase in this ratio could indicate that liquidity is weakening; management may need to make adjustments to manufacturing schedules and purchasing patterns.
Comparing days cost of sales in inventory among divisions or product lines can also be helpful to determine whether any areas require special attention. Comparing this ratio with industry averages will establish how your enterprise is performing. Ideally, a company should turn its inventory at approximately the same rate as competitors to avoid both inventory gaps and obsolescence. As well, banks often set a maximum limit on the amount of loan margin allocated to inventory because in a liquidation situation they do not want to take possession of inventory. Thus it’s helpful for many reasons to utilize the days cost of sales in inventory ratio to assist in maintaining an optimal inventory level.
5. Current ratio
(also: working capital ratio)
Weathering slow periods requires adequate cash. If the current ratio (total current assets – total current liabilities) is in decline, this could be an indication that a company is experiencing difficulty meeting short-term commitments.
The current ratio is commonly included in operating loan covenants – especially for inventory-intensive manufacturers. It is not difficult to fall out of covenant during slow sales periods since the current ratio reflects the availability of current assets to make payments.
Thus if the current ratio is trending down, it’s important to scrutinize current assets and liabilities to identify where problems may be developing and to institute corrective measures. You might, for example, look for opportunities to rebalance accounts receivable collections and accounts payable trade terms to minimize the company’s reliance on banking facilities.
These days, banks are quick to react to companies that fall even slightly off covenant or under margin on loans or operating lines of credit. Losing a credit facility could be catastrophic for a company during an economic downturn.
Comparing forecasts with financial statements and reviewing these five ratios prior to monthly bank monitoring will ensure that management can anticipate any problems before lenders do. While no company can be completely immune to economic hardship, gross profit, breakeven analysis, days sales in accounts receivable, days cost of sales in inventory, and the current ratio can help management respond knowledgeably to financial challenges and allow the team to focus on the company’s priority: building the core business.
