Ratio analysis is a powerful tool for measuring the performance of your business.
Why Measure?
When advised to calculate the various ratios that measure the health of service businesses, many nearly-bankrupt shop owners have answered, "Why should I measure anything? After all, I sell parts and labor as high as my competitors, keep expenses low, and work long hours. How can I do any better by calculating anything?" Although this line of reasoning seems logical, it proves to be very wrong in actual practice.
If you were to go boating without a destination in mind, and without having a compass or any landmarks to prove whether or not the boat was on course, it's likely you soon would be drifting into undesirable or dangerous locations. This applies also to your business. Allowing it to drift along according to whatever seems expedient at the moment, without any indications either of improvements or of dangerous trends, permits everyone but you to manage your business.
Use Ratio Analysis
By now, you should have definite business goals in mind (this is the "destination"). Next, you need performance measurements of each financial area. One type of valuable measurement is RATIOS. The figures for ratio calculations come from your monthly P&L statements and balance sheets, which you should have already.
The value of figuring ratios is that you can use percentages, not dollars. With ratios, the size of your business doesn't prevent you from comparing your profits and costs with other similar shops.
Ratios Are Simple
The words "ratio analysis" sound complicated and impressive. We see visions of rows of accountants working busily with computers. Not so. Today, with only an inexpensive electronic calculator and your own figures, you can figure your ratios - all of them -easily, and in just a few minutes.
You will need your latest annual P&L statement and balance sheet.
For examples, we are using the figures for Dick's TV, in Table 1 and Table 2.
Current Ratio
One of the best-known measures of financial strength is the "current ratio." It answers this principal question: "Does your business have enough current assets to meet its current debt, with a margin of safety for possible losses, such as inventory shrinkage or uncollected accounts?" The formula has only three parts: Current ratio equals current assets divided by current liabilities.
From the Dick's TV balance sheet (Table 2), the current assets are $14,000 and the current liabilities are $7,000. Dividing the liabilities into the assets gives a current ratio of 2.0 (or 2 to 1). Is this a favorable current ratio? According to the popular rule-of thumb, it is exactly right, because 2 to 1 is considered to be good. However, the "safe" ratio area differs from business to business, so no one can give an absolute figure.
We will supply you with estimates that are as accurate as possible, and you'll learn quickly what is proper for your own business, after you become familiar with ratios.
Now, suppose Dick's current ratio calculated as only 0.5 to I (meaning, the dollar amount of liabilities was twice that of the assets). What actions should he take? First, he must realize that his current ratio indicates serious problems. If business volume decreases, he won't be able to pay his bills, even by selling the inventory and collecting all accounts receivable.
He should take one or more of the following steps:
• borrow money with a loan that matures next year or later;
• convert some fixed assets (such as unused test equipment, or an extra service vehicle);
• increase the equity by adding more of his own cash to the business; or
• increase the profits, retaining the increase in the business.
Probably, the best remedy is the last one--increasing the profits and keeping the increase in the business.
Parts Sales Ratio
One of the most likely causes of unprofitable service is an insufficient percentage of gross profit from parts sales. There are several reasons why parts sales might not be profitable. Some parts list prices from the manufacturers don't allow sufficient markup to take care of the inevitable inventory losses. Per haps a part is installed as a test, but the labor cost to remove it--if not needed--would exceed the cost of the part. So, the part is left in the machine. The cost should be changed to a labor cost, but it probably is ignored, becoming shrinkage of the inventory. Also, warranty replacement parts require handling expenses, without any compensation from markup. All of these situations reduce the profit from parts. You must know the actual percentage of parts profit before you can make effective plans for improving the situation.
Parts profits divided by parts sales (both in dollars) equal the gross parts-profit ratio. Dick's TV had a cost of $25,000 and sales of $50,000, for a profit of $25,000. This is a ratio of 1 to 2 or 0.50, which usually is expressed as a percentage (50%). Years ago, a 40% profit was considered to be very good. But, service shops now need to have 50% or higher gross profits.
Gross Labor Profit Ratio
In many shops today, a 50% labor gross profit would represent a giant improvement. Yet, a 50% profit is barely acceptable. In fact, a profitable service business needs a 60%, or higher, labor gross profit.
In other words, each technician should bring in an average of no less than 2 1/2 times his wages. Thus, your direct labor costs should not exceed 40%. Dick's TV gross labor profit ratio is: labor profit ($25,000) divided by labor sales ($50,000). The ratio is 0.50, or 50%, which is below the ideal figure.
To remedy this below-optimum condition, Dick has two choices:
• increase the productivity of his technicians (they receive the same wages, but bring in more money); or
• increase the labor rates.
Owner's wages
Too many small shops fail to include any wages for the hours the owner spends working as a technician. If this is not included, it produces a false labor cost and an untrue labor profit.
For example, the calculation that does not include any owner labor cost might show an inaccurate labor gross profit of 50%, whereas it should be 10 %, if his own labor contributions were included.
Table 1 Dick's TV Service Profit and Loss Statement 1-1-77 to 12-31-77
Overhead Ratios
The prices of parts and labor are extremely important, because they are the largest cost items. All other expenses (rent, utilities, insurance, advertising, expendable supplies, etc) are called "overhead" or "operating expenses." Your business efficiency might be measured by the overhead percentage. Lower over head percentages indicate better efficiency.
Although few service shops appear to waste much money on unnecessary items of overhead, the total of all expenses is a sizable sum, and it should be examined to assure the least possible waste.
The overhead expense ratio is obtained by dividing the total overhead expenses by the total sales. With Dick's TV, the overhead was $40,000 which was divided by total sales of $100,000 to produce an overhead ratio of 0.40 (or 40%). It's advisable that you never allow this percentage to exceed 50%. Dick should compare his over head expense percentage each month against that of previous months. Any significant increase should alert him to examine the reasons for the increase. If the percentage drops below 40%, he can assume that the expenses are not out of line.
Expense variations
The percentage of overhead expense will vary drastically from shop to shop. If you are a one-man operation, and using your home for the business (without charging your self rent or depreciation), the percentage might be small (perhaps 20%). At the other extreme, some large shops have overhead costs up to 50%, when the owner's salary is included in the overhead.
Therefore, a "safe" figure is difficult to establish for overhead ratio or expense. Compare your percentage against that of other shops, but be sure the accounting is done by the same method.
Of course, you always can com pare your monthly overhead percentage against other months.
Profitability Ratios
After you have paid yourself (and your partner, or other working shareholders) a fair wage for any direct participation as manager or technician, you should test to determine whether or not the business was profitable. There are several ways of measuring profit.
One way is the "return on investment" percentage.
The return on investment ratio equals the net profit (Dick's TV had $10,000) divided by the net worth ($16,000). This is 0.625, or 62.5%, which is excellent! Especially, since Dick had paid himself as a manager and technician.
If your return on investment in dollars is lower than the interest you could have drawn on your net worth (if deposited in savings), you have lost money. But, don't feel discouraged. Many owners do much worse.
For example, some shop owners consider their salary to be the business profit. They are misleading themselves. If Dick's sole compensation for the year had been the $10,000 net profit, then it actually was wages for himself, leaving no net profit for the business! On the other hand, if the $10,000 is listed as business net profit, the situation is even worse. He had an employee (himself) working for the business without pay. He should have been paid at the same rate as anyone else who performed the same work. If he had been paid
$15,000 per year, than the business would have shown a $5,000 loss, and not a profit. In that case, the return on investment would have plummeted to a minus 31%. Remember to keep your salary as manager or technician separate from the business profit. This error has robbed many a shop owner.
Other Ratios
After you have discovered how easy ratios are to work with and to understand, you will want to com pare other financial areas. Table 3 lists many of these ratios you will want to calculate in the future.
Some are reciprocals of other formulas that you won't need very often.
Use the table to remind you of the important ratios which should be compared regularly.
Remember, your constant use of ratio analysis can spot unfavorable trends in time to solve them. You can work more confidently when you know your business is healthy.
Table 3 IMPORTANT RATIOS FOR YOUR BUSINESS
(adapted from: Electronic Servicing magazine, Aug. 1978)
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