“So, based on my calculations,” Becky said, “we would need to make sure that the new employee has at least 20 hours of billable work a week in order to pay for his salary.”
“That’s right,” said Vivian. “And you were telling me that, with your expected increase in commercial construction work, you should easily be able to get the 20 hours. So it makes sense to hire an employee.”
“I’ll get the ad in the paper today,” said Becky.
You want to calculate your capacity. Look at the following figures:
Number of hours in a work year (per person) — 1,950
Average number of hours spent on admin. activities — 250
Number of hours available to charge to clients — 1,700
Average charge-out rate — $75
Each of the three consultants should be able to charge out 1,700 times $75 annually to clients. This is then multiplied by the number of consultants:
1,700 X $75 X 3 = $382,500
This means that the maximum revenue with your current cost structure is $382,500. It would be ridiculous to budget for revenue of $500,000 without planning for a new staff member.
Chapter Summary
• Fixed costs are costs that do not change with volume of sales.
• Variable costs are costs that do change with changes to the sales volumes.
• The break-even calculation tells you how much of your product or service you have to sell in order to cover your fixed costs.
• The capacity calculation tells you the maximum number of units of your product or service you can produce or provide with your current operating facilities.
4
Ratio Analysis for Fun and Profit
In this chapter, you will learn —
• Why ratio analysis is critical to successful businesses
• The basic ratios and what they tell you
• How to pick the ratios that best foretell your business’s success
• What to do when ratios indicate a problem
• How to integrate ratios into your management reporting system
The subject of ratios is one that makes most small business owners’ heads hurt. Financial analysts and stockbrokers regularly assess the ratios of large, publicly traded companies, but many small businesses do not even consider ratios when they prepare their financial information. Why should you care about ratios? Consider the following reasons:
• Your bank will certainly care about monitoring ratios. They want to see how you’re doing in comparison with other businesses that they are lending to, and in comparison to the standards they have set for lending.
• Ratios are excellent indicators of financial health. Much like a high blood pressure or cholesterol reading at your doctor’s office would signal impending physical trouble, out-of-kilter ratios signal financial trouble for your business.
• Ratios are a useful tool for comparing your business activities year over year. For example, is your working capital ratio steadily improving or not? (We will discuss this and other ratios later in the chapter.)
• Ratios are a useful tool for comparing your business activities with those of other businesses. Without using ratios, it can be difficult to compare businesses of different sizes.
Case Study
“Ratios? That sounds too much like math!” Joe wrinkled his nose.
“Ratios are just one piece of the management operating plan, Joe,” Vivian explained. “Ratio analysis is one of the most powerful tools for guiding your business going forward. Besides, once you have the whole process set up, it takes very little time to maintain it.”
Becky added, “Remember how you’re always telling me that you think our accounts receivable are out of control? Well, now we’ll be able to know for sure and to track it on a regular basis.”
“Well,” Joe said slowly, “show me how the accounts receivable ratio works. Then we’ll see if it does us any good.”
The Basic Ratios and What They Tell You
Ratios can be grouped into different categories based on the type of information they provide:
• Solvency or liquidity ratios (e.g., current ratio, total debt ratio)
• Asset and debt management ratios (e.g., inventory turn-over, times interest earned, payables turnover, receivables turnover)
• Profitability ratios (e.g., profit margin, return on assets, return on investment)
Check out Table 1 at the end of the chapter for a summary of all the ratios we’ll discuss.
Solvency or liquidity ratios
Solvency ratios (sometimes called liquidity ratios) indicate how well your business can pay its bills in the short term without straining cash flows. As you can well imagine, your lenders are usually quite interested in the short-term solvency of your business. (They want to make sure they get their money back!) Some commonly calculated solvency ratios are:
• Current ratio
• Total debt ratio
Current ratio
The current ratio is one of the best measures of whether you have enough resources to pay your bills in the next twelve months. It is calculated as —
Current ratio = Current assets ÷ Current liabilities
The current ratio can be expressed in either dollar figures or times covered. For example, a business has total current assets of $4, 325 and current liabilities of $3, 912. The business’s current ratio would be —
Current ratio = Current assets ÷ Current liabilities
= $4,325 ÷ $3,912 = 1.11 : 1
In other words, for every dollar in current liabilities, there is $1.11 in current assets. You could also say that the business has its current liabilities covered 1.11 times over. For a refresher on current assets and current liabilities, refer to Bookkeepers’ Boot Camp, the first book in the Numbers 101 for
