Less than three ratios and financial analysis. Here are the five things we're going to cover in this lesson. First, we're going to test a company by calculating key liquidity, safety, leverage and efficiency ratios to will analyze results and learn how to interpret the ratios financial impact and what it means in your business three will diagnose the causes for any financial or management problems that results are pointing to for be able to build solutions to improve your company's health based on what you find and five, build a financial dashboard you can use in your company with cash flow tool. Today we're going to talk about analyzing a company actually going through a ratio analysis and I've picked a real life company I've worked with in the past. It has the financial statements that are listed in the supplemental information along with the industry averages. So you might want to Get those out because you can use them to follow along as I go through the ratio analysis.

And we'll do cause and effect, we'll do financial impact. And we'll look for the actual problems that this company needs to address. So if you're ready, let's get started. One of things I like to do is set up the scene. So we're going to work with a company I call spectrum manufacturing and spectrum manufacturing is a 60 year old paint company, what they're trying to do is look for and just as just to give an example, just to give it a scenario, they're looking for a line of credit of $300,000. But what we're going to do is analyze the company, like a banker, like an investor, like a financier would, and take a look at just how healthy this company actually is.

Now, a lot of times when I do this, I have people that just start all over the place. There's no methodology for actually looking at a company. So what we want to do is I want to show you right up front on when you get your hands on financial statements. Where do you start? Right, I see a lot of people start in a lot of different places. So I'm going to teach you a methodology that I call the initial financial indicators, or IFRS.

Now I have five, initial financial indicators are just four or five things that you can look at real quickly and get a real good grasp on what's going on in the company, before you do a long in depth ratio analysis. So let me show you how we do that. If you want to get out your financial statements, you'll see that we have a balance sheet and an income statement for spectrum manufacturing. Now there's five years worth of financial so that we can look at look at history on five different years. You'll see it your one is on the left hand side. And on the right hand side is your five.

Now your five is the newest year, the most current year. It helps you you can think about year one in year five is 2011 to 2015 kind of gives you a chronological view of it. So we're going to be looking at the trend of course but your five is kind of what's happening right now. So let me show you what the eyes are It starts off with something we all go to. I mean, we all take a look at trends, right? And there's four things I look at specifically, I look at sales, gross profit, operating expense, and net profit.

Those are the four that I look at. These are pretty simple, pretty easy. And I don't care how we do it, how you look at it. But when you first take a look, what you want to do is look at what's happening. Now, with my accountant, I used to make them have a little chart, little dashboard. And I don't care if it was a bar chart.

Or if there's a line chart, heck, it could be an arrow, it doesn't matter to me, but what I did want was to know the magnitude of change, right? So I had to have dollars I mean, could it be up $10 could be up a million dollars, but I want to know the dollars as well as the trend If it was up or down. So let's take a look at the first one. The first one is just sales. When I pull it up year one to year five, in year one, he had 8.1 million and your five he had 7.1 million. So think about that.

He's now in a million dollars in sales. It really doesn't look good right off the bat all sudden, we see that the trend over the last five years is down a million dollars. carrying that right now to gross profit. And I'm going to tell you before you start anywhere, gross profit is the most important number on the income statement, the absolute most. And the reason I say that is that it is the only place that you can go to get cash. If you're going to spend cash and operating expenses or you're going to keep cash in your pocket in the form of profit.

This is where it comes from, not your sales, your gross profit. So gross profit is the single most important in my mind. And we will look at sammies, Sammy was the name of the owner of spectrum manufacturer. He had $2.6 million in gross profit in year one. Then in year five, he had 2.1 million. So it was about $450,000 decline.

So sales were down and so it was gross profit. Now, people might say well, do you expect that actually you do right? Expect it. If somebody is managing the gross profit, that means gross profit should be moving in line with their sales. So as sales goes up, so it just goes profit and sales goes down. So does gross profit.

And you expect them to move in about the same pattern, right as they go up. And now, in this case, it's okay to see sales coming down and gross profit coming down because they should be moving together. Now, it's interesting because I also like to look at the relationships between numbers. So if sales was actually coming down, but gross profit was coming up, that'd be a cool situation actually see, because what's happening is we're doing less work in sales, but we're making more money. I don't know what's causing it just yet. But it's a good relationship to see when you're making make more money and do less work.

Okay, so the third trend I look at is actually operating expense. This is how we spend our gross profit. And in this case, in year one, we were at about 2.4 million is what we spent and then in year five, we were spending back $2 million. Think about that. That's actually pretty good, because he actually operating expense came down. So he was actually trying to cut expenses.

He saw sales coming down. He saw gross profit coming now. So we also cut expenses. So I'm thinking, you know, right off the bat first glance, that's a good deal, right? He's actually trying to, you know, cut expenses as the sales and gross profits coming down. Here's what's important.

I mean, is it the right amount did he cut enough? Well, we don't know that yet. But at least we can see it and he's actually doing it. And you gotta remember some about operating expenses. Unlike gross profit and sales, which moved together, operating expenses don't move with sales or gross profit. They actually take a management decision to move right so I either add expense or cut expense, but a manager has to do it, it doesn't move with sales.

Okay, so he came down. We're going to say about $350,000 a way I see it about 350,000 dollars. Now, I'm using the kiss method, right, I'm rounding just a little bit, I'm going a million dollars in sales, I'm going 450 in gross profit, I'm going 350. In operating expenses, we're around a little bit the kiss method is keep it super simple, right? That's what we're doing at this stage is the first glance at it. You don't got to get exactly to the penny.

But it gives us in the ballpark that things are coming down. The last one is net profit. And of course, I'm gonna look at net profit before tax because taxes are just a result. In this case, in year one, we made about $126,000. But in year five, it was down to 11. So something went wrong, right, because we're down almost $100,000 in net profit.

Now remember, net profit is a result, there's nothing I can do to the net profit line, I have to work on my sales or my gross profit or my operating expense to make an impact on net profit. In this case, he's lost about $100,000. So that's our ifI number one, and I'm going to show you for today. So I find number one is trends. I'm looking at sales, gross profit, operating expense and net profit. And my first impression of this company is, well, he's in trouble, right?

Because everything is going down. So we can't stop there though, right? Just because sales are going down, gross profits coming down, sometimes business cycles and work like that. So let's dig a little bit deeper and see what's really going on in this company. So I find number two, very simply put, is a hard fast rule. If you violate this next rule, your company will die.

I'm just going to be very honest with you. It cannot sustain longevity. It can be a long living company. If you violate this rule, it's an expense control rule. And basically, the rule says the change in operating expense should mirror the change in gross profit. So the change in operating expense should mirror the change in gross profit.

Here's what I mean. Simply put, if gross profit is the money that we can spend, and operating expenses is the way we spend it. If I have less money to spend, I should Yeah, you guessed it spend less money. So having less money to spend, I should spend less money. So as gross profit comes down, so should operating expense, I'm sure yes looks in a graph, right? So if we graph out sales, sometimes you'll see sales.

Runners come fluid, sometimes it's up sometimes it's down, not usually very sharp. I mean, a lot of more mature companies that kind of just flows. And if we're doing things right, we're a successful business owner that manages to gross profit, which means we got a good pricing strategy. We were working with our our vendors, we have a solid, gross profit margin that we can track to. It should track just in line with sales. So you get your gross profit and your sales line that kind of move together.

But like we said, operating expenses don't move that way. They move differently. Right, they move more if we graph them out in a stair step manner. They're going to kind of go up and go flat. Why? Because again, it takes management decisions to move operating expenses.

So we're moving operating expenses, we made the decision to add, what do you think is a reason that people add expense, which generally, because they hit a capacity, they hit the wall, right? As they're growing, they either have to add more people, they have to add a vehicle, maybe they add a location, but they're going to add expense to keep up with demand, keep up with capacity to fund growth, they have to add expense to be able to fund their business in a growth environment. So as gross profits coming up, you'll see operating expenses go up and then level off and they level off because we're trying to make more money. The longer we can keep our expenses flat, especially in gross profits going up, we'll make more money. Now, what's interesting is that as gross profit starts to come down, then our operating expenses should kind of start to pay attention, right?

Meaning that we can't just keep climbing on operating expenses as gross profits coming down. Now, we make money when our operating expenses are less than gross profit. What happens when our operating expenses though, are equal to gross profit? That's called breakeven. So when gross profit is equal to operating expenses, there's no profit made. There's no profit lost.

It's just breakeven. And that's generally where you see these two lines cross. That's the danger point, right? When those two lines cross, that's when you should be saying, oh, the next thing is going to happen is I'm going to lose money. When the lines cross. That's when we need to make the decision to actually cut expenses, right?

And how much should you cut? Well, if you have $100,000 less to spend, you should cut $100,000. Right? Because the rule says the change in operating expense should mirror the change in gross profit. So that's what we're talking about. And the longer you keep Operating Expenses above gross profit, which means you're spending more than you're bringing in, the more money you lose.

I used to tell people leave, and I used to be a state trooper. And people would say, Hey, Mike, how fast can I drive? And I would tell him the same answer every time. You can drive as fast as you can afford. Of course, I was trying to be funny. But the answer holds true here.

How long can you operate at a loss? Well, as long as you can afford, but chances are, you're going to hurt your company. So here's the rule, change your operating expenses in the same quantity as your gross profit. In our company's case spectrums case, they actually changed gross profit, it came down $450,000 but they only cut $350,000 worth of expenses. So think about that. They have $450,000 less to spend, but they only cut three $150,000.

So, the expense control problem exist. And we see the net profit. Remember when they had $126,000 in net profit five years ago, and then 11 this year, that's about $100,000. And it showed up right here and expense control. So my advice to them would be cut $100,000 and make your gross profit and your operating expenses the same. So that's ifI.

Number two, its expense control. And expense control is a change in operating expense should mirror the change in gross profit. Okay, I find number three. I find number three is a tough one. Right? We're starting to get into math.

We're starting to get into where our advisors actually take us. Used to be you couldn't start a business unless you had three people on your team. You'd have a banker, an accountant and a lawyer. Right. And all the more on the pedestal with business owner. Something happened in 2000 An eight, right the bankers kind of fell off the pedestal, we don't pay attention them anymore.

Matter of fact, they ranked seventh behind other people will even talk to you. So how do we put the banker back on the pedestal? Because as we grow, our businesses need money. And there's going to be a point in time when you have to take on debt. So how much debt Can you have? How much should you ask for?

How much is available to your business? Or do you have too much already? This is one of the metrics that you use to well control that and it's called debt to equity, the debt to equity ratio. Now some people go debt to equity white, why is that? You know, so important and why did you even bring up advisors? Well, debt to equity ratio is the ratio that puts a business owner in the middle of two of the advisors.

You get two of your trusted people, the accountant and the banker that are giving you good advice. But it's opposite right once telling you to do one thing. The other is telling you to do exactly the opposite. And believe me They're both right. They're just not both right at the same time. So it's up to you, Mister business owner to be able to determine who's right at the right time.

And here's what I mean by that. The accountants main position in your company, outside of recording your financial information is to really minimize your taxes. That's right, he's going to employ your tax strategy. And one of the strategies that they use is to reduce your net income, you know, through expenses through depreciation methods through a whole host of different strategies that they employ in your business. But the main purpose is to reduce net income. Why?

Well, because we pay tax on net income, so the lower than any income, the lower the tax. Remember in Lesson One, when we talked about how the income statement and the balance sheet are connected, yeah, net profit becomes retained earnings on the balance sheet. So when I have less net profit, I actually have less retained earnings and retained earnings as part of the equity section. The He in the D divided by E. equation, so in equity. So when I'm putting less money into equity, I'm actually not funny my company properly. And here's what this tells a banker This is really a measurement of how well you believe in your company.

Are you willing to put your own money? And what I mean by that is do you keep profit inside your own company? And here's how they measure that is using the debt to equity ratio. How do they calculate it? Simply put, here's how it makes you look at when you go to buy a house. Right?

Chances are they want you to put about 20% of the purchase price down that's what your equity as the owner is, right? So the E and D equation, view your equity in the house. That means the bank is putting in 80% so they have 80% of the purchase price you have 20 and if you divide 80 by 20 that equals four so yeah, got it for right now. Here's what that means. For every dollar you put into the house. You let The bank put in four.

And they think that's a safe ratio on a house because it's a big market, they can probably get rid of it if I have to take it back as part of a loan default, but four is the number they're looking at, right? Four or less. So the more money you put in, the lower that number goes, right. So if I was to do a higher number, so to speak, maybe I only put in 10%, and then make put in 90%. Well, 90 divided by 10 would be a nine, nine would be more risk to the bank. So the higher the number here, the more risk to the bank.

So this is the number they look at. So when you have less equity, such as the 20% of the house versus 10% of the house, you're actually creating more risk for the bank. So the banker Of course, once you do, yeah, probably pay more tax, but you have to also have more equity in your company. So how are they going to look at it? They're going to look at two different lines on your balance sheet. One is total liabilities.

The other is total equity. Right? And if we look At sammys company, Sammy in the equity line has 1.4 million 1465. On his liabilities he owes currently $2,000,118. So 2118 divided by 1465 equals 1.45. Right?

One more four, five. Yeah. What does that mean? Well, that means for every dollar same, he's putting his company, he's let the bank put in $1 45. Was that good or bad? Well, if I'm buying a house, it's really, really good.

But the banks look at a smaller number for businesses, when they're willing to lend $4 to $1. In a house, that number is reduced to 2.5. So $2 and 50 cents for every dollar you put in your business. They want you to be at $2 and 50 cents or less. So this debt to equity ratio we're looking for, if you need a loan is 2.5 or less. Right.

So in this case, Sam is doing pretty well. He's a 1.5 For five, which means he actually has about $1 more he can take on from the bank. It's really important that we manage it. But how do I know when to do the right thing? And believe or not, you have to look out 12 months. So next year, do I think I'm going to need a loan next year from the bank?

And if the answer is yes, start paying attention the debt to equity today, which means I need to be looking to get my debt to equity ratio to 2.5 or less if I'm expecting to apply for a loan next year. So use it that way. That's the answer to the banking test in this case is 2.5. You want this number debt equity to be 2.5 or less. And Sammy actually has two interesting we've looked at three if he's got bad trends. He's got bad expense control, but he does have the ability to take on more debt.

He's actually pretty good there. He hasn't he hasn't taken on too much as it is. So number three is debt to equity. Which leads me to the last one, we're gonna look And the last one we're gonna look at is even though, right? Even is not even a foreign word, I mean, don't don't don't think about it that way. But eba is something that most business owners don't even consider because it's a proxy, a substitute word for cash flow.

And bankers use it to actually compare like companies, well, how do they do it? How does it work, even as earnings before interest, taxes, depreciation, amortization. The purpose of the eba equation is to level the playing field, it takes out all the effects of financing decisions, or accounting decisions that we make as business owners. I might use debt financing or use equity financing. I might use straight line depreciation where you might use double declining balance depreciation, this smooth all that out so they can compare me and my business to your business. eba is just about cash flow, what is the real money that comes through this company?

So how do you calculate it? Pretty simple. You're going to take earnings after tax. In this case, we have $9,000. Coming right off year five of the income statement, then we're going to add in all the others, you're going to add in interest. And you add an interest because bankers will do it a couple different ways a it smooths out the financing, we're used debt and I didn't.

So if I don't have interest in you do, it gets added back in. So it's still part of your cash flow. It also is used in bankers calculations for total debt, and they don't want to count interest twice, and their new calculation and what you already have on your income statement. The next one is taxes that you pay and taxes are just a result, everybody's got to do it. And we make different accounting decisions so we can pay less tax. So we add taxes back in again to put everybody on a level playing field.

The next two are pretty interesting because they're non cash expenses. depreciation, amortization, we depreciate things we can touch, we amortize things we can't. So you're building your equipment, your vehicle You're going to depreciate though. Your patents or trademarks, your goodwill if you bought another company is amortized. When we looked at sammys company, he had $183,000 in depreciation, but no amortization. And if your company doesn't have amortization, that's okay.

Right? 90% of the small smaller businesses out there don't have amortization unless they bought a company. So when I add up nine plus 129 interest, we've got $2,000 in taxes, and we have 183,000 in depreciation that gives us an EBITDA a $323,000. Yay, 300 323 actually looks a lot better than the 9000 that we posted. So the base we'll look at is actually $323,000 available for cash to service debt and other things in this business. So what do I do with how do I as a business owner, use this?

Have you ever been in a situation Where you go to the bank and he just, you know, you need a loan, but you don't know how much to ask for? Well, this is going to put you in a ballpark or when you're trying to forecast growth, this is going to tell you how much money you might need for growth or how much is even available to you. So on average, across the US, even at times three equals the long term debt capacity. That's a lot more complicated than that. But if we're just doing a rule of thumb before just in our offices, and we're trying to get in the ballpark, you take eba, you multiply it by three, and that's going to give you your long term debt capacity, which means in sammys case, a spectrum manufacturing is $323,000. And the Buddha would qualify him for about 969,000.

Let's just call it a million dollars in long term debt. So he's eligible for about a million dollars in long term debt. It's a good number to know that I can actually borrow up to a million. Now, you can't stop there, when you're looking at your company where we're looking at sammies, right now, what you have to do is say okay, what does he already have on the books. So when we looked at the balance sheet, he had 599,000 in long term debt already. So if you go to the balance sheet and see that your five is long term debt is 599,000.

So we take the 969 that he has as the ceiling and subtract what he already has the 599, which gives him availability of 370,000. So, if we're rounding it's about $400,000, that he has available, it's a good number. No, again, if you walk into a bank, you'd like to be able to say, Hey, I like to borrow $400,000. Rather than saying I'd like to borrow a million, which is too much, which means your company can't support it. So that's fine. Number four, and we went through all the files now.

Now we can dig into the meat because we found out that his trends are poor. His expense control is poor, is a debt to equity is actually Pretty good, and he has some ability to borrow here and long term debt. So it's not all bad, but it means that we need to dig a little bit deeper. And now let's do some ratio analysis. If you want to get out your financial statements and the industry average page, we'll go through the financial analysis together.