Liquidity as a Key Indicator

1. Current Ratio

This ratio can be calculated as follows,

Current Ratio = Current Assets/Current Liabilities

This ratio contemplates on identifying the organizations ability to meet shot term liabilities. Generally a ratio between 2 to 3 is considered good. The lower the ration it means that the company has difficulties in meeting the short term obligations.

In the case of lower ratio these variables can be further expanded. Liabilities within 3 months time, 6 months time, 9 months time, 12 months time and whether the current assets can be managed to meet the liabilities in a timely manner.

2. Cash to current Asset Ratio

This ratio can be simply calculated as follows,

Cash to CA = Cash/ Current Assets

This ratio will highlight the management of cash which the most liquid asset. Higher ratio could indicate that the company is holding on to cash without thinking of investment opportunities.

3. Quick Asset Ratio

Quick assets ratio only takes into account the most liquid assets and gives a better measurement of the company's liquidity.

Quick ratio = Liquid current assets (Cash, securities, accounts receivables)/ Current liabilities

In this ratio the inventory and other low liquid assets are removed thus gives a good indication of the company's ability to meet the current liabilities.

4. Cash Ratio

Cash ratio can be calculated as follows,

Cash Ratio = Cash and cash equivalents/ Current liabilities

In this ratio the account receivables are also removed and thus give an indication of the availability of immediate assets to cover up the current liabilities.

5. Receivable turnover Ratio

This ratio can be calculated as follows,

Receivable turnover ratio = Sales Revenue / average Receivables

Average receivables can be calculated as follows,

Average receivables = (Previous account receivables + current account receivables)/2

This provides an indicator of the company's credit policy mainly. Higher ratio implies that the company is collects dues from its customers quickly. A high ratio compared to competition might indicate that the company's credit policy somewhat risk averse where the company does not provide enough credit facility and might be loosing on sales opportunity.

6. Average Number of days receivable outstanding

This ratio can be calculated as follows,

Avg No: of days = 365 / Receivable Turn over

Thus this gives the number days the receivables are out standing. If the ratio is expanded we can arrive at the following ratio,

Avg No: of days = (Average Receivables * 365)/Sales Revenue

This ratio gives an insight to the credit management policy of the company.

To arrive at better insight you would analyze deep into,

a) Who are the company's suppliers? What is the breakdown supplier by supplier based on credit performance?

b) Is the company dependent on few suppliers or does it have a large number of supplier bases?

7. Inventory Turn over Ratio

This ratio can be calculated as follows,

Inventory Turnover = Cost of goods sold/average inventory

This ratio signifies the effectiveness of inventory management. A high ratio would indicate that the company is managing its inventory well which enables the company to manage the working capital more effectively.

A very high ratio also may indicate that the company does not maintain sufficient levels of inventory thus leading to loss of potential customers.

A company which is practicing concepts like just in time would have a very high inventory ratio.

a) How effective is the re-order level? How effective is warehousing?

b) What is the average lead time of a supplier?

8. Payable Turnover Ratio

This can be calculated as follows,

Payable turnover = Annual purchases / average parables

This ratio can be further broken down into,

Annual Purchases = Cost of goods sold + Closing inventory - Beginning inventory

Average payables = (Current payables + Current Payables in the previous year)/2

This ratio explains how much of credit the company uses from its suppliers. This ratio is calculated when checking the credit ratings and a low ration could indicate that the company does not get much credit from its suppliers.

This may be because,

a) The company does not have a good credit history with suppliers

b) If the suppliers have a very high bargaining power they might negotiate a very low credit period

9. Average Number of Days Parables Outstanding

This ratio can be calculates as follows,

Average number of days parables outstanding = 365/payable turnover

This ratio is quite similar to the ration discussed in the above section. This ratio tries to express the credit period using days.

This ratio is also defined as the average age of payables.

10. Cash Conversion Cycle

This ratio can be calculated as follows,

Cash conversion cycle = average collection period + average number of days in stock - average age of payables

This ratio highlights the speed of conversion of collections into cash. A high amount ratio could imply that the company has invested on sales in the pipeline maintaining higher number of days in stock and with high collection period.

11. Defensive Interval

This ratio can be calculated as follows,

Defensive interval = 365 * (cash + marketable securities + accounts receivable)/ operational expenses

This ratio is used to identify the worst case scenario to identify how long the company can survive incurring its normal operational expenses without generating sales.

Operational expenses are funded with the current assets and this gives the number of days the company can survive without generating sales.

A higher ratio will imply that the company is maintaining a lot of current assets. To conclude on the utilization of current assets ratios like current ratio, quick asset ratio should be considered.

Health check of a company
This document contemplates on presenting an analysis ratios and how to use these ratios to analyze a company. Ratios are derived from the three main financial statements which are profit and loss statement, balance sheet and cash flow statement. And this is the most scientific way to understand a company’s performance.
The following is an extract of a profit and loss statement.

Sales Revenue	2000
Cost of Sales	(1200)
Gross profit	800
Distribution Costs	(400)
Administrative Expenses	(240)
Other Income	40
Profit before Tax	200
Income Tax Expenses	(50)
Profit for the year	150

1. Gross Profit Margin
Gross Profit (GP) Margin can be calculated as follows,

GP Margin = (Gross Profit/Sales Revenue) %

In this Scenario the gross profit margin of the company is 40%.

What does this ratio mean? Does this mean the company is doing well? Is the company performing exceptional? The main objective of this document is to develop the ability to analyze a company based on the financial performances.
When analyzing a ratio the most important thing is to break down the ratio into to atomic units to understand the insight of the ratio.

Gross profit (Sales Revenue – Cost of sales)
Sales Revenue (selling price per unit * No: of units)
Cost of Sales (Opening inventory + Purchases – Closing Inventory)

Gross profit margin could increase mainly because sales revenue increasing or the cost of sales is being reduced.
For the sales revenue to increase either the selling price of a unit should increase or the number of units should increase.
You would like to know the answers for the following questions to conclude.
Questions
a) Has the company increased the selling price to earn higher revenue but has it decreased on the number of units sold.

b) If the number of units being sold is decreasing is there high competition in the market, what is the market share of the company?

c) Has the sales revenue increased/ decreased compared with the previous years? What is the percentage increase in sales Revenue?

d) How are competitors doing?

When analyzing ratios it should be critically appraised and should always question the atomic principles of the ratios.

For the gross profit to increase the other things possible is that the cost of sales has increased. Cost of sales gives insight to the effectiveness of the supply chain management of the company.
With reference to the breakdown of the cost of sales you should try to look for answers on,
a) Has the opening stock increased or decreased?

b) Has the closing stock increased or decreased?
*Company which has implemented Supply chain management concepts like Just in Time would not have an impact on closing and opening stock on the Cost of goods sold

c) Has the cost of purchases increased/Decreased compared to previous years. Has the inflation levels impacted the cost of purchases.

2. Percentage change in Revenue
This Ratio is important to benchmark the sales revenue against the performance of the previous years.
% Change = [(Sales in base year – Sales in previous year) /Sales in Previous year] %

This will give insight to the company’s performance on sales on a year on year basis. In the example since the company has increased the percentage of growth in the year 2010 it could be concluded that the company is well.

Yet this could have happened due to other reasons such as ill performance of competition where its customers coming to our company.
A better analysis would dig deep into the sales revenue trying to understand the variations of selling price and the units.

3 Percentage change in selling price
% Change = [(Selling price in base year – Selling price in previous year) /Selling price in Previous year] %

4 Percentage change in number of units sold
% Change = [(No: of units in base year – No: of units price in previous year) /No: of units in Previous year] %

Let’s apply these two ratios to the given scenario.

Deeper analysis shows that the prices of the product have increased but the number of units has decreased.
a) Has the sales price increased due to inflation or is the company focusing on a premium pricing strategy?

b) How are the competitors doing on pricing?

c) The number of units are decreasing drastically are these customers switching to competitors? How to get the lapsed customers back to the company? Are the competitors reducing prices to attract customers?

Building this analytical thinking would enable to master in ratios and better analyze a company’s portfolio.

5. Compound Annual growth Rate (CAGR)

This ratio contemplates on arriving at an average figure to for the year on year growth rate.
You can use the following ratio to calculate it
Future Value (FV) = Present value (PV) (1 + Rate(R)) ^ Number of years
In applying to the above scenario,
FV = 2000, PV = 1800, R=?, Years = 2
After applying the values to the formula you get a CAGR of 8.475%, this presents an average value for the year on year revenue growth, and this can be used as a bench mark to compare the growth rates for each year. For instance in compared with the CAGR year 2010 the company has done well in terms of sales. This ratio could be used to compare with competitors.

6. Percentage Change in Cost of sales
% Change = [(COGS in base year – COGS in previous year) /COGs in Previous year] %
This Ratio gives insight to the direct cost structure direct costs related to the company.
Increase in this ratio could be due to many reasons,
a) Increase in the inflation of the country

b) Weak supply chain management, change in suppliers.

c) Weak management in the inventory levels

This ratio could decrease,
a) Better management in supply chain, Change in suppliers
Companies may select low cost suppliers to reduce cost of sales, but it is important that suppliers are selected not purely based on the price variable. As lower quality inputs could lead to low quality outputs (Garbage IN – Garbage OUT)
b) Decrease in Inflation, Taxes which affects in decreasing the cost of inputs.
Trying to analyze the ratios from a critical perspective enables to get into more insight.

7. Distribution cost as a percentage of Sales
This Ratio is important to understand how well the company is using the channels. This could be calculated as,

Distribution cost as a percentage of sales =
Distribution costs/Sales Revenue%

This revenue explains the effectiveness of managing distribution channels which is normally the responsibility of the procurement department. In this explain this ratio 20%. Decreasing in the revenue highlights better management of distribution channels.
a) This ratio could change based on the number of units sold as to distribute more products distribution cost would increase but maintaining a stable portfolio is important.

b) Based on the target geographical area, this ratio might change since distribution costs increases based on the geographical span covered.

To arrive at a better conclusion it is better to compare the ratio with previous year’s figures.

8. Profit before Interest and Tax (PBIT) Margin
PBIT Margin = PBIT/Sales Revenue%

Let’s consider a break down of the PBIT.
PBIT = Gross Profit – Operational Expenses
Thus for the PBIT margin to increase either the gross profit should increase or the operational expenses should decrease. How to increase the gross profit was discussed in the earlier sections of this document and thus see how we can reduce the operational expenses.

The operational expenses consist of the administration expenses, depreciation, distribution costs. An improvement in the PBIT margin signifies that the company is better managing the above mentioned operational expenses. Thus this ratio clearly highlights the managerial capability and thus this can be used as a performance measurement of the management of the company.

9. Interest Cover
Interest cover can be calculated as follows,
Interest Cover = PBIT/Interest Expenses

This ratio will give an indication of the company’s burden in debt expenses. The lower the interest cover the company is ridden by debt.
To understand this lets see how interest expense is calculated.
Interest Expense = Debt * Annual Debt Rate


Higher the interest expense is higher the company’s debts. For the company to afford the finance cost or the interest cost it is important that PBIT covers the expenses. If the Ratio is below 1.5 company’s ability to meet interest expenses is questionable.
For a better analysis answers to following issues might need to be looked into.
a) The company might not been looking to optimize its capital structure

b) The company might be charged high interest rates and the company might not be effective in finding lower cost financing means.

c) The countries economic policy and due to high inflation interest rates might have gone up.

10. EBITDA

EBITDA is the earnings before interest, tax, depreciation and amortization.
EBITDA = Revenue – Expenses (Excluding Tax, Interest, Depreciation, Amortization)

This ratio is very important to compare profitability among competition because it eliminates the accounting and financing decisions. For instance a company adopting a reducing balanced depreciation policy may have higher depreciation costs in the initial year after the purchase of assets in compared with a company which is adopting a straight line method to calculate depreciation.
And also different companies adopt different strategies to finance operations. For instance a listed company can use a rights issue to finance which is lower cost of finance in compared to borrowing.

11. EBITDA to Interest Cover
This ratio can be calculated as follows,
EBITDA to Interest Cover = EBITDA/ Interest Payments

This Ratio assesses a company’s profitability at least to pay the interest expenses. A ratio greater than 1 indicates that the company has coverage to pay off its interest expenses.
EBITDA eliminates the cost of depreciation and amortization thus would give a better indication of the financial durability of the company.

12. Profit after tax Margin
Profit after tax is also known as the earnings attributable to share holders. Since only after arriving at the profit after tax the company decides on the dividends and the amount of retained earnings. This ratio can be calculated as follows,

PAT Margin = Profit after Tax / Sales Revenue %

PAT margin in the above example is 7.5%. In other words for each $100 sold the company generates a net profit of $7.5.
To arrive at a conclusion on profitability, a year on year basis profit variance should be calculated, and also compared with the competition.
An increase on sales does not necessary mean that the profit margins would improve. If the cost structure increases at a higher rate the profit margin will be affected. This ratio will give a good indication about the cost management.

13. Pre tax Margin
Pre tax margin can be calculated as follows,
Pre Tax Marin = Profit before tax/ Sales Revenue%

In the above example the pre tax margin accounts to 10%. Comparison of the pre tax margin with after tax margin will show the tax margin.

14 Contribution Margin
In understanding the contribution margin, it is important to define contribution,

Contribution = Sales – Variable Costs

The difference between contribution and profit is that contribution does not take into account the fixed costs. This ratio is important for product profitability analysis.

The contribution margin can be calculated as follows,
Contribution Margin = Contribution / Sales Revenue%

Variable costs are mainly the direct costs in line with the product or service, thus contribution margin will highlight the effectiveness in managing the direct costs with relate to production. Better analysis would try to find answers to the following
a) Comparison of the contribution revenue with the net profit margin. This will highlight the fixed asset portion

b) What is the method company used to absorb overhead costs? Can we propose Activity based costing to improve profit calculations?

Ready for Green Consumerism?

In the recent past organizations extensively contemplate on being green. The main goal is to minimize the carbon foot print, which leads to adverse environmental consequences that we see now, with unimaginable changes to the whether patters, and the environment. Thus companies have realized the importance of being responsible, to ecological balance which makes the world we live in a wonderful place to be.

Nowadays, being green attracts a lot of publicity and attention which ultimately compounds to the organizational brand. The question is how many companies genuinely contemplate on being green as oppose to a brand building stunt. One of the key models marketers use in segmenting the green consumers is NMI’s Consumer segmentation model, which is also known as LOHAS customer segmentation. The image is the LOHAS customer Segmentation done for USA, and the percentages are of the total population.

Customer Segment	Description
LOHAS	LOHAS consumers are highly concerned over both personal and planetary health. Key characteristics are, a. They make environmentally friendly purchases (Green Products) b. They support advocacy programs and actively take parts in Environment protection movements
NATURALITES	Main characteristic is that they are highly concerned over their personal health, strong health focus on food and beverages and consumers organic food. Unlike LOHAS there are not actively involved in environment protection movements
DRIFTERS	This segment has good intentions however; the key factor behind purchase decision is not environment. It could be price, quality and trend. Thus Drifters have number of reasons for not being green.
CONVENTIONALS	Conventionalist are not green driven how ever they are more cost efficiency focused and keen on recycling, reducing power consumption, energy preservation thus these segment indirectly contributes to the greenism of the society
UNCONCERNED	Environment and society are of less priority to this segment.

Thus it is evident from the above classification, how consumers mind set works and there is so much potential on the LOHAS market for green products. Green branding is the ultimate WIN-WIN situation which makes green consumers happy, enhances company brand and diminishes environmental harm.

Evolution of the Business Orientation

It is amazing how history has molded businesses in defining the fundamentals of doing businesses. This change is evitable in the Business Orientation evolution, from extensive focus on product orientation businesses have evolved to market orientation. Now the consumer is at the core of business strategy and strategy formulations is structured through extensive focus on customer satisfaction

Orientation	Time	Description
Production	Up to 1950s	In this era the core focus of organizations was on the most effective and efficient product methodology. Under this method organizations focused on increasing production to generate economies of scale and operated with the assumption that consumer preference does not change frequently. The famous saying of Henry Ford “People will buy cars as long as it is black”
Product	Up to 1960s	Organizations contemplated on the quality of the product, extensive focus was on improving the product. The core assumption in this orientation was that product superiority is the main benefit that customers sought after. This orientation went into an extent where a mouse trap was developed in gold.
Selling	1950s to 1960s	Selling concept contemplates on using extensive selling methodology to sell products. The focus was on using promotional methods in pursuing customers to make the purchase decision. Companies sought after the skill of Selling and the money question in that era was “How to sell a fridge to an Eskimo?”
Marketing	Since 2007	The marketing orientation was the peak at the evolution of business orientation. With mistakes in history business realized the importance of identifying, anticipating and satisfying customers at profit is the way forward. Since the only source of income to any company is from revenue generated from customers, thus it was established that it is important to focus on consumers.
Market	Recently	One of the key weaknesses in Marketing orientation was that a key function was developed in organizations called marketing and the marketing department was held responsible in the satisfaction of consumers. This concept evolved with the understanding that it is not only the responsibility of a single department or function, all the functions should be customer oriented and decision making should be based on consumer satisfaction.

It is evident how business orientations have evolved learning from the mistakes. Customer is at the core of business strategy, how delighted customers are is directly proportionate to the profits of the company.

Do you have a Core Competency?

To survive in this competitive environment, as an individual it has become so essential that a person should develop a core competency, the X-factor that would enable the person to differentiate. While I was doing some analysis I came across this amazing model ((Source: Johnson, G, Scholes, K, Whittington, R Exploring Corporate Strategy, 8th Edition, FT Prentice Hall, Essex, 2008, ISBN 978-0-273-71192-6)where most of the companies use to build core competencies.

This model presents a methodology of creating that core competency that would enable you to create a sustainable competitive advantage. Put yourself in to this four quadrant model. Do you have resources that no one else has? Resources could be inherited assets from parents, immense network of relationships, Land and buildings in prime locations. An individual could start this analysis by listing down the number of resources that the individual has and prioritize them based on the importance,

then see what are the resources that the individual has better than competition. In the Sri Lankan Context, Otara the entrepreneur who built the ODEL (www.odel.lk) fashion brand had a house at the core center of the main city in Sri Lanka. That was a resource that she had which gave a her distinctive advantage over the competition. When she started the shop at this prime land, the start was perfect as per the 7 Ps model in Marketing concept the place variable gave her a disproportionate advantage. from the rest.

Different people have different types of competencies, some are highly competent in public speaking, some are highly competent in article writing, and some have amazing singing competencies. The challenge is in transforming these competencies to core competencies. Doing better than competition and making it difficult to imitate. Start now in investing on developing a core competency. Core Competency will give you enhance the value of an individual, and once built it should be leveraged.