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Business
Ratios and
Formulas
A COMPREHENSIVE GUIDE
Steven M
...


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Business ratios and formulas : a comprehensive guide / Steven M
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Includes index
ISBN 0-471-39643-5 (cloth : alk
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Business mathematics
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Title
HF5691
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01'513—dc21
2002071306
Printed in the United States of America
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Acknowledgments

To Sheck Cho, the editor I have known longer than anyone
else in the publishing business
...


Contents

About the Author
Preface

xv
xvii

1

Introduction

1

2

Asset Utilization Measurements
Sales to Working Capital Ratio
Sales to Fixed Assets Ratio
Sales to Administrative Expenses Ratio
Sales to Equity Ratio
Sales per Person
Sales Backlog Ratio
Sales Returns to Gross Sales Ratio
Repairs and Maintenance Expense to
Fixed Assets Ratio
Accumulated Depreciation to Fixed Assets Ratio
Fringe Benefits to Wages and Salaries Expense
Sales Expenses to Sales Ratio
Discretionary Cost Ratio
Interest Expense to Debt Ratio
Foreign Exchange Ratios
Overhead Rate
Goodwill to Assets Ratio
Overhead to Cost of Sales Ratio
Investment Turnover
Break-Even Point

vii

5
6
7
9
10
11
13
14
15
17
18
19
20
21
22
24
26
27
29
30

viii / Contents

Margin of Safety
Tax Rate Percentage

31
32

3

Operating Performance Measurements
Operating Assets Ratio
Sales to Operating Income Ratio
Sales Margin
Gross Profit Percentage
Gross Profit Index
Investment Income Percentage
Operating Profit Percentage
Operating Leverage Ratio
Net Income Percentage
Profit per Person

35
35
37
38
39
40
41
42
43
45
46

4

Cash Flow Measurements
Cash Flow from Operations
Cash Flow Return on Sales
Fixed Charge Coverage
Expense Coverage Days
Cash Flow Coverage Ratio
Cash Receipts to Billed Sales and Progress Payments
Cash to Current Assets Ratio
Cash Flow to Fixed Asset Requirements
Cash Flow Return on Assets
Cash to Working Capital Ratio
Cash Reinvestment Ratio
Cash to Current Liabilities Ratio
Cash Flow to Debt Ratio
Stock Price to Cash Flow Ratio
Dividend Payout Ratio

49
49
51
52
53
55
56
57
58
59
61
62
63
64
66
67

5

Liquidity Measurements
Accounts Receivable Turnover
Average Receivable Collection Period
Days Delinquent Sales Outstanding
Days Sales in Receivables Index
Accounts Receivable Investment
Ending Receivable Balance

69
69
71
72
73
74
76

Contents / ix

Inventory to Sales Ratio
Inventory Turnover
Inventory to Working Capital Ratio
Liquidity Index
Accounts Payable Days
Accounts Payable Turnover
Current Ratio
Quick Ratio
Cash Ratio
Sales to Current Assets Ratio
Working Capital Productivity
Defensive Interval Ratio
Current Liability Ratio
Required Current Liabilities to Total Current
Liabilities Ratio
Working Capital to Debt Ratio
Risky Asset Conversion Ratio
Noncurrent Assets to Noncurrent Liabilities Ratio
Short-term Debt to Long-term Debt Ratio
Altman’s Z-Score Bankruptcy Prediction Formula

77
78
81
82
83
84
85
86
87
88
89
90
92
93
94
95
96
98
99

6

Capital Structure and Solvency Measurements
Times Interest Earned
Debt Coverage Ratio
Asset Quality Index
Accruals to Assets Ratio
Times Preferred Dividend Earned
Debt to Equity Ratio
Funded Capital Ratio
Retained Earnings to Stockholders’ Equity
Preferred Stock to Total Stockholders’ Equity
Issued Shares to Authorized Shares

103
103
104
106
107
109
110
112
113
114
115

7

Return on Investment Measurements
Net Worth
Book Value Per Share
Tangible Book Value
Return on Assets Employed
Return on Operating Assets

119
119
121
122
123
125

x / Contents

Return on Equity Percentage
Return on Common Equity
Financial Leverage Index
Equity Growth Rate
Earnings per Share
Percentage Change in Earnings Per Share
Economic Value Added
Dividend Payout Ratio
Dividend Yield Ratio
8

Market Performance Measurements
Insider Stock Buy-Sell Ratio
Market Value Added
Stock Options to Common Shares Ratio
Cost of Capital
Sales to Stock Price Ratio
Price/Earnings Ratio
Capitalization Rate

9

Measurements for the Accounting/Finance
Department
Purchase Discounts Taken to Total Discounts
Percentage of Payment Discounts Missed
Transactions Processed per Person
Transaction Error Rate
Average Time to Issue Invoices
Average Employee Expense Report
Turnaround Time
Payroll Transaction Fees per Employee
Time to Produce Financial Statements
Percentage of Tax Filing Dates Missed
Proportion of Products Costed Prior to Release
Internal Audit Savings to Cost Percentage
Internal Audit Efficiency
Bad Debt Percentage
Percent of Receivables over XX Days Old
Percentage Collected of Dollar Volume Assigned
Percent of Cash Applied on Day of Receipt

126
127
129
130
131
132
133
136
137
139
139
141
143
144
147
148
149

151
152
154
155
156
157
158
160
162
163
164
165
167
168
169
171
172

Contents / xi

Cost of Credit
Earnings Rate on Invested Funds
Brokerage Fee Percentage
Borrowing Base Usage Percentage
10

11

Measurements for the Engineering Department
Bill of Material Accuracy
Labor Routing Accuracy
Percentage of New Products Introduced
Percentage of Sales from New Products
Percentage of New Parts Used in New Products
Percentage of Existing Parts Reused in
New Products
Average Number of Distinct Products per Design Platform
Percentage of Products Reaching Market before
Competition
Ratio of Actual to Target Cost
Warranty Claims Percentage
Time from Design Inception to Production
Percentage of Floor Space Utilization
Measurements for the Logistics Department
Production Schedule Accuracy
Economic Order Quantity
Number of Orders to Place in a Period
Economic Production Run Size
Raw Material Inventory Turns
Raw Material Content
Finished Goods Inventory Turns
Obsolete Inventory Percentage
Percentage of Inventory > XX Days Old
Percentage of Returnable Inventory
Inventory Accuracy
Percentage of Certified Suppliers
Electronic Data Interchange Supplier Percentage
On-Time Parts Delivery Percentage
Purchased Component Defect Rate
Incoming Components Correct
Quantity Percentage

173
174
175
177
179
179
181
182
183
184
186
186
187
188
190
191
192
195
196
197
198
199
200
201
202
203
204
205
206
208
209
210
212
213

xii / Contents

Percentage of Actual Payments Varying from
Purchase Order Price
Percentage of Purchase Orders Issued
below Minimum Dollar Level
Proportion of Corporate Credit Card Usage
Percentage of Receipts Authorized by
Purchase Orders
Freight Audit Recovery Ratio
Picking Accuracy for Assembled Products
Average Time to Ship
On-Time Delivery Percentage
Percentage of Products Damaged in Transit
Percentage of Sales through Distributors

218
219
220
221
223
224
225

12

Measurements for the Production Department
Constraint Productivity
Constraint Rework Percentage
Constraint Schedule Attainment
Constraint Utilization
Degree of Unbalance
Throughput Effectiveness
Break-Even Plant Capacity
Manufacturing Effectiveness
Productivity Index
Unit Output per Direct Labor Hour
Average Equipment Setup Time
Unscheduled Machine Downtime Percentage
Acceptable Product Completion Percentage
Work-in-Process Turnover
Scrap Percentage
Warranty Claims Percentage
Maintenance Expense to Fixed Assets Ratio
Indirect Expense Index
Reorder Point
On-Time Delivery Ratio

227
228
229
230
231
232
233
234
236
237
239
240
241
242
244
245
247
248
249
250
252

13

Measurements for the Sales and Marketing
Department
Market Share

255
255

214
215
217

Contents / xiii

14

Customer Turnover
Browse to Buy Conversion Ratio
Recency
Direct Mail Effectiveness Ratio
Inbound Telemarketing Retention Ratio
Quote to Close Ratio
Sales per Salesperson
Sales Productivity
Sales Effectiveness
Sales Trend Percentage by Product Line
Product Demand Elasticity
Days of Backlog

256
258
259
260
262
263
264
265
266
268
269
270

Measurement Analysis with an Electronic
Spreadsheet
Financial Statement Proportional Analysis
Financial Statement Ratio Analysis
Automated Ratio Result Analysis
Leverage Analysis
Trend Analysis
Forecasting
Cash Flow Analysis
Capital Asset Analysis
Compounding Analysis
Investment Analysis
Risk Analysis

273
274
275
278
279
281
283
286
288
290
292
295

Glossary
Appendix: Measurement Summary
Index

297
303
327

About the Author

S

teven Bragg, CPA, CMA, CIA, CPM, CPIM, has been the chief financial officer or controller of four companies, as well as a consulting manager at Ernst &
Young
...
Mr
...
He has also written the following books: Accounting and Finance for Your Small Business (Wiley), Accounting Best Practices (Wiley), Accounting Reference Desktop (Wiley),
Advanced Accounting Systems (Institute of Internal Auditors), Controllership
(Wiley), Cost Accounting (Wiley), Financial Analysis (Wiley), Just-in-Time Accounting (Wiley), Managing Explosive Corporate Growth (Wiley), Outsourcing
(Wiley), Sales and Operations for Your Small Business (Wiley), and The Controller’s Function (Wiley)
...
It contains performance measurements
for the accounting, engineering, logistics, production, and sales departments
...
In addition, the book includes measurements
related to asset utilization, operating performance, cash flows, liquidity, capital
structure, return on investment, and market performance
...

There are nearly 200 measurements in this book
...
The cautions are of particular use since they describe the
elements of a measurement that can be modified to deliver misleading results, different measurements that may work better in certain situations, use on a trend-line
basis, and other measurements that should be used to reinforce indicated results
...
This is especially useful for investors and financial personnel, who need to compile
information about a company’s long-term performance
...
Managers can choose the correct blend of measurements to
achieve an information set that can be used for feedback on strategy initiatives and
specific efficiency projects, as well as for performance evaluations
...

Centennial, Colorado
August 2002

xvii

1
Introduction

E

very department in every business produces some kind of information that can
be used by its manager to measure performance
...
Unfortunately, managers may not be aware of the multitude of measurements that can be used to track these different levels of performance or of the ways
that these measurements can yield incorrect or misleading information
...
Chapters 2 through 13 itemize a series of performance measurements for different aspects of a company
...
There are also specialized ratios
that deal with such issues as sales returns, repairs and maintenance, fringe benefits, interest expense, and overhead rates
...

Chapter 4 contains cash flow measurements, which are useful in determining
the ability of a company’s cash flows to keep it in business
...
Chapter 6 contains capital structure and solvency measurements, which determine the relationship between a company’s debt and equity, as well as the comparative proportions
of different types of stock
...

Chapter 7 contains return on investment measurements, which encompass net
worth, several types of return on assets and equity, earnings per share, economic
value added, and return on dividends
...

Chapters 9 through 13 cover measurements for individual departments
...
In contrast to Chapters 2 through
8, which are devoted to measurements that are primarily used by the accounting
and finance functions, Chapters 9 through 12 are more concerned with such issues
as work capacity levels, efficiency, and effectiveness, which in many cases require
no financial information at all
...

Chapter 14 covers a variety of topics related to measurements using the Microsoft Excel electronic spreadsheet, including how to set up comprehensive sets
of measurements that can be used for proportional, leverage, ratio, and trend
analyses
...

The book concludes with an appendix and glossary
...
This list
should only be used with the precautions given for them in their respective chapters to ensure their proper use
...

The chapters containing measurements (Chapters 2 through 13) have an identical structure
...
Thereafter, each chapter is broken down into the discussion of individual measurements
...
The description typically notes how the measurement is used
and who uses it
...
The example is generally a complete
scenario that describes how the measurement is used in a simulated business situation
...

The reader may use this book to search for a single calculation, which can be
used for highly targeted needs
...
For example, a CFO might be interested in a company’s stock market
performance and therefore watches only the price/earnings ratio
...
A more rounded set of measurements might

Introduction / 3

include the days of sales backlog (since it indicates future changes in sales volume), production capacity utilization (since it shows the ability of the company to
produce its incoming sales), and the days of accounts receivable (since it shows
the company’s ability to convert sales into cash)
...

Even if a company has developed a reasonable set of measurements, this does
not mean that they should never be changed
...
For example, inventory accuracy can improve only to 100%
...
However, there will be a few measurements, usually involving sales levels
and break-even points, that will always be the centerpiece of any measurement
system, since they bring attention to bear on the most crucial revenue and cost elements of the business
...

This book is filled with nearly 200 financial and operational measurements that
have proven to be of considerable use to the author in tracking the performance of
many companies in a variety of industries
...
com
...
There are several that require additional information from the balance sheet, as well as internal information, such as employee
headcount, that may not be readily discernible from published financial statements
...
There are also
specialized ratios that deal with such issues as sales returns, repairs and maintenance, fringe benefits, interest expense, and overhead rates
...
Each section also discusses how each ratio or formula can be misused, skewed, or incorrectly applied
...
One of the best
ways to determine changes in the overall use of cash over time is the ratio of sales
to working capital
...
It is most effective when tracked on a trend line, so that management can see if there is a long-term change in the amount of cash required by
the business in order to generate the same amount of sales
...
Similarly, if the management team decides to increase the speed of order fulfillment by increasing the amount of
inventory for certain items, then the inventory investment will increase
...
This ratio is also used for budgeting purposes, since budgeted
working capital levels can be compared to the historical amount of this ratio to see
if the budgeted working capital level is sufficient
...
One should not use annualized gross sales in the calculation, since this would include in the sales figure
the amount of any sales that have already been returned and are therefore already
included in the inventory figure
...
It achieves its
inventory goal rapidly by selling back some of its inventory to its suppliers in exchange for credits against future purchases
...
1
...
1

Revenue
Accounts receivable
Inventory
Accounts payable
Total working capital
Sales to working capital ratio

Quarter 1

Quarter 2

Quarter 3

Quarter 4

$320,000
$107,000
$640,000
$53,000
$694,000
1:0
...
30

$290,000
$97,000
$320,000
$48,000
$369,000
1:0
...
33

Asset Utilization Measurements / 7

The ratio calculation at the end of each quarter is for annualized sales, so we
multiply each quarterly sales figure by 4 to arrive at estimated annual sales
...
Inventory drops in the second quarter to
arrive at the new inventory turnover goal, while the amount of accounts payable
stays at one-half of the revenue level, reflecting a typical distributor’s gross margin of 50% throughout all four periods
...

Cautions: As stated in Table 2
...
Also, arbitrarily lengthening the terms of accounts payable in order to reduce the working capital investment will likely lead
to strained supplier relations, which may eventually result in increased supplier
prices or the use of different and less reliable suppliers
...
For example, the oil-refining business requires
the construction of a complete refining facility before any sales can be generated
...
This is a particularly effective measure when compared to the same ratio for other companies in the same
industry; that is, if another company has found a way to generate profitable sales
with a smaller asset investment, then it will be rewarded with a higher valuation
...
For example, a printing facility may have
achieved 100% utilization of its printing plant, and so cannot generate more sales
without a multimillion dollar investment in new equipment
...

Formula: Divide net sales for a full year by the total amount of fixed assets
...
One is to calculate annualized net
sales on a rolling basis, so that the last 12 months of revenue are always used
...
The denominator in the
calculation, which is the amount of total fixed assets, may be used net of depreciation or before depreciation; the most common usage is after depreciation, since
this is more indicative of the actual value of the assets
...
Both variations on the formula
are shown here:
Annualized net sales
—————————
Total fixed assets
Annualized net sales
——————————————————————
Total fixed assets prior to accumulated depreciation
Example: The Turtle Tank Company creates tracked vehicles for a number of

military organizations
...
The trouble with this order is that the company’s existing capacity can only handle 10 more
tanks per year
...
The price the company will receive for each tank is $850,000
...
Based on these
numbers, its net sales to fixed assets ratio will change as shown in Table 2
...

The Turtle Tank Company is a publicly held company, so its management is
concerned that the much lower ratio that would be caused by the new investment
would not compare favorably to the same ratio for its competitors
...
An alternative solution for the situation is for the managers to ignore
the short-term impact of the ratio and instead to focus on the key issue, which is
whether there will be enough additional business in the future to justify the additional investment
...
For this reason, it is better to calculate the measure for individual businesses or product
lines
...

Table 2
...
7:1

$76,500,000
$60,000,000
1
...
For example, a company with a strategy of selling
very small orders to its customers requires a large accounting department, not only
to issue a vast quantity of invoices, but also to process a large number of payments
...
In these cases, it is important to ensure that the administrative expense is carefully controlled, so that it does not have an excessively
large impact on profits
...
It is better to use the last twelve months of net sales for the annualized net sales figure, rather than an estimate of sales for future months, since the
look-forward estimate may be substantially incorrect
...
The formula is:
Annualized net sales
——————————————————
Total general and administrative expenses
Example: The Windy Weather Gauge Company has experienced a sharp drop in

sales volume
...
1 to 1:0
...
This relative expense increase will certainly have a major
negative impact on profits
...
Finding that the primary expense in this area is salaries, the controller quickly determines that there are so few
personnel in each of the administrative areas that only outsourcing or the merging
of departments will allow the company to achieve its previous sales to administrative expense ratio
...

Thus, quick action based on this ratio allows the company to shrink its administrative expenses down to a level that will ensure continuing profits
...
However, if there
is a significant change in sales volume, this is a less clear relationship
...
Conversely, a significant drop in sales

10 / Business Ratios and Formulas

volume may still require a company to leave much of its general and administrative
expenses in place, due to long-term contracts that cannot be voided (such as building leases) or the presence of significant fixed assets (such as computer centers) that
cannot be reduced to reflect the smaller sales volume
...


SALES TO EQUITY RATIO
Description: This ratio is used to determine the amount of equity that should be

retained within a business as sales volumes fluctuate
...
If so, the required
cash can come from debt, internal cash generation, or equity
...

Formula: Divide annual net sales by total equity
...
The formula is:
Annual net sales
———————
Total equity
Example: An examiner for the Friendly Tax Collection Service calls on a com-

pany that has paid out no dividends for the past few years
...
3
...
3
2000
Sales
Retained earnings
Other equity
Total equity
Total fixed assets
Sales to equity ratio

$12,500,000
$5,000,000
$350,000
$5,350,000
$2,500,000
2
...
1:1

2002
$15,500,000
$7,500,000
$350,000
$7,850,000
$2,600,000
2
...
9:1

Asset Utilization Measurements / 11

This table reveals that the company is extremely profitable, with over a million
dollars being added to retained earnings in every year
...
The sales to equity ratio shows that the amount of equity in the
business is continuing to rise in relation to sales
...

Cautions: If a company is already highly leveraged, the amount of equity is so

small that the sales to equity ratio has no particular relevance
...
Consequently, a company’s financing decisions have a great deal of influence over this ratio
...
It is based on the assumption that employees are at the core of a company’s
profitability, and so high degrees of efficiency in this area are bound to result in
strong profitability
...

Formula: Divide revenue for a full year by the total number of full-time equiva-

lents (FTEs) in the company
...
For example, two half-time employees would be counted as one
FTE
...
This measures the productivity of those personnel who are directly connected to the manufacture of a company’s products or
services
...
The formula is:
Annualized revenue
————————————————
Total direct labor full-time equivalents
Example: The operations manager of the Twirling Washing Machine Company

wants to determine the sales per person for the company, both for all staff and just

12 / Business Ratios and Formulas

the direct labor personnel
...
2 million
...
However, if the part-time staff all work halftime, then the eight part-time positions can be reduced to four FTEs, which decreases the total headcount to 50 personnel
...
The company can use any combination of these groups for its sales per
direct labor measurement, as long as it consistently applies the measurement over
time
...
If this approach were
not used, the person doing the measuring might be tempted to artificially inflate
the measurement results by shifting direct labor personnel into other labor categories that fall just outside the definition
...
The employee figure of 31 was derived by adding 22 direct labor personnel to the three FTEs represented by the 6 part-time direct labor personnel, plus
the production supervisors and materials-handling staff
...
For example, shifting away from employees to an outsourced solution or to the in-house use of temporary employees can artificially reduce the number of FTEs, as can the use of overtime by a smaller number of
employees
...
Also, some capital-intensive industries have so few employees in relation to the sales volume generated that this measure has much less
significance than other measures, such as sales to fixed assets
...
Nonetheless, if the backlog information is available, this
ratio should be used as an extremely useful tool for determining a company’s
ability to maintain its current level of production
...
Conversely, a rapid jump in
the ratio indicates that a company cannot keep up with demand, and it may soon
have customer relations problems from delayed orders and need additional capital expenditures and staff hirings to increase its productive capacity
...
It is gen-

erally best not to use annualized sales in the denominator, since sales may vary
considerably over that period, due to the influence of seasonality
...
The formula is:
Backlog of orders received
———————————
Sales
A variation on this formula is to determine the number of days of sales contained within the backlog, which is achieved by comparing the backlog to the average daily sales volume that a company typically produces
...
4
...
The change was caused by an increase in the
company’s productive capacity for additional cell phones
...
However,

Table 2
...
55:1

$4,750,000
$2,000,000
0
...
36:1

14 / Business Ratios and Formulas

the management team must be aware that, if the present trend continues, the company will eventually clear out its entire backlog and find itself with a sudden reduction in sales, unless it greatly increases its sales and marketing efforts to build
the backlog back up to a higher level
...
It is also of limited use for highly seasonal businesses,
since their intention is to completely clear out their backlogs at the end of the selling season and then build up inventory for the next selling season, even in the absence of a backlog
...
An excessive level

of returns can be indicative of product flaws requiring replacement, or an overly
generous returns policy, or the sudden appearance of a competing product on the
market that distributors would rather keep in stock
...

Formula: Divide total sales returns by gross sales
...
To avoid this problem, the ratio should be aggregated on a rolling quarterly basis, so that returns will be more likely to be matched against related sales
...
Table 2
...


Table 2
...
6

3-Month rolling sales
3-Month rolling returns
Returns ratio

Oct

Nov

Dec

Jan

Feb

Mar

$81,500
$7,400
8%

$208,500
$8,650
4%

$835,500
$21,350
3%

$810,000
$83,550
10%

$678,000
$81,000
12%

$51,000
$67,800
133%

This table shows that there is a time lag of exactly one month on all sales returns, and that the return rate is always exactly 10% when compared to the gross
sales from which the returns originated
...
To fix this problem, the controller elects to measure the ratio on a rolling three-month basis, which smooths
out the ratio somewhat, as shown in Table 2
...
However, the returns attributable
to the December sales month occur in January, which therefore still appear in the
March three-month rolling measurement when the corresponding sales have
dropped out; to avoid this problem, reporting the measure could be delayed by one
month on an ongoing basis, so that the most recent month’s returns could be divided by the sales from the preceding month
...
For example, a company can offer free extra products or services to a
customer who wishes to make a return rather than accepting the returned goods
...
Also, unusual returns, such as
products that are being called back to the factory to repair a serious flaw, may be
recorded against a special loss reserve
...
By any or all of these means, a company can hide the true amount of its sales returns
...
If the ratio follows an increasing
trend line, then the company is probably in need of some asset replacements
...
Of particular interest is an increasing ratio that suddenly drops with no corresponding increase in the amount
of fixed assets, this indicates that a company is running out of cash and cannot afford to repair its existing assets or purchase new ones
...
If the expense is broken down into subcategories,
such as between production equipment and facilities, then the measure can be calculated for each category presented
...
The formula is:

Total repairs and maintenance expense
————————————————
Total fixed assets before depreciation
Example: The Hot Cinnamon Candy Company is being examined by the due

diligence team of another candy company, which may decide to make an acquisition offer
...
7
...
Of particular concern is the sudden drop in the
amount of repairs expense in 2003, because there is no corresponding increase in
the fixed assets account that would indicate that new assets have been purchased
...

Cautions: As noted earlier, the ratio can be manipulated by company manage-

ment if it chooses to delay making expenditures on needed asset repairs
...
Also, the amount of repairs and maintenance
expense can be manipulated by shifting the salaries of the equipment repair staff
to some other overhead category or outsourcing the work
...


Table 2
...
For example, if the proportion of accumulated depreciation
to fixed assets is quite high, it is evidence that not too many assets have been
added by a company in recent years, which may in turn lead one to suspect that
there is little cash available for such investments
...
A variation on this approach is to run the same calculation for different
classes of assets, in order to see if there are certain types of assets in which a company does not appear to be making a sufficient level of investment in new assets
...
The financial information under review is limited and does
not contain a sufficient degree of information regarding cash flows from year to
year
...

The assumption is that an increase in the ratio of accumulated depreciation to fixed
assets over time is an indicator of a shortage in cash
...
8
...

Cautions: This ratio can present an incorrectly unfavorable view of a company’s

reinvestment policy if the company has taken an aggressive approach to depreciation, using accelerated depreciation calculations and short estimated time periods

Table 2
...
Under this treatment, depreciation levels will
rise rapidly, leading one to believe that a company’s asset base is older than it really is
...
Finally, a company’s accounting staff may not be making journal entries that would eliminate
from the balance sheet the asset cost and accumulated depreciation associated
with assets that are no longer on the premises
...


FRINGE BENEFITS TO WAGES AND SALARIES EXPENSE
Description: Apparently small changes in a company’s benefit policies can have

a profound impact on the total benefits expense for a company
...
This is also a useful measure when comparing the
overall fringe benefit costs of two companies that are considering merging, so that
the surviving entity can calculate the potential savings to be made by shifting the
other company’s benefit plan to that of the acquirer
...

Formula: Add together the cost of all discretionary benefit costs, minus the cost

of any related deductions from employee pay, and divide this amount by the total
of all wages, salaries, and payroll taxes
...
It needs to find ways to cut
expenses after the acquisition in order to prove to its shareholders that the transaction is cost-effective
...
Since this is a hostile takeover attempt, FGC is not cooperating in providing
detailed benefits information to AGC
...
The AGC acquisition team prepared Table 2
...

The table reveals that, though the total dollars associated with fringe benefits
for both companies are nearly the same, the proportion of fringe benefits to wages

Asset Utilization Measurements / 19

Table 2
...
By reducing this percentage to 19% (the same one achieved by AGC), the acquirer can reasonably estimate that a savings of $296,000 can be achieved by using its benefits package at
the acquiree
...
Also, unusual
one-time benefits, such as Christmas bonuses, can cause unusual spikes in the
ratio in the months when these benefits are paid out; later this problem can be resolved by accruing for one-time benefits over all months, thereby smoothing out
their impact
...
This
ratio is useful for determining the variable cost of sales, so that management can
determine if the sales system must be altered to result in a less expensive approach
...
Since sales expenses in-

curred may not result in sales for several months, it is best to calculate this ratio
on at least a quarterly basis
...
The
basic formula is:
Sales salaries + Commissions + Sales travel expenses + Other sales expenses
————————————————————————————————
Sales
Example: The Moving Cart Corporation (MCC) manufactures food carts for
street vendors
...
Further investigation reveals the information in Table 2
...


20 / Business Ratios and Formulas

Table 2
...
7%

$7,500,000
$2,925,000
39%
$400,000
$285,000
$2,325,000
–$85,000
9
...
A
change in the sales method, from traveling to customer locations to some less personalized approach, is clearly in order
...
g
...
g
...
This may render the ratio difficult to use as a comparative tool
...
A high ratio of discretionary costs to
sales means that there are considerable opportunities for expense reductions
...
Discretionary costs can include

marketing, research and development, training, and repairs and maintenance costs,
as well as any other costs that do not directly contribute to ongoing sales or production activities
...
To do so, they have obtained a great deal of debt financing, which must be paid off by cutting deeply into the company’s discre-

Asset Utilization Measurements / 21

Table 2
...
To see if this option will work, the Chief Financial Officer has constructed the list of discretionary costs shown in Table 2
...

In addition to the $1,083,000 of discretionary costs, the company already generates $650,000 of cash flow, for a total available cash flow of $1,733,000 if all
discretionary costs are not incurred
...
75%
...
Based on
this information, the company can pay the interest on the loan, which costs
$965,250 after taxes ($15,000,000 × 9
...
The
management team decides that it is too risky to withhold these discretionary costs
for the many years required to pay off the debt, and withdraws its buyout offer
from consideration by the board of directors
...
For example, the complete elimination of all
marketing costs will eventually destroy a company’s market share, while delayed
repair costs will cut into the useful productive capacity of the manufacturing department and may take some equipment completely out of action
...


INTEREST EXPENSE TO DEBT RATIO
Description: This ratio is useful for determining the approximate interest rate

that a company is paying on its debt
...

Formula: Divide the interest expense by the sum of all short- and long-term
debt
...
The
formula is:

22 / Business Ratios and Formulas

Table 2
...
The investor obtains the information in Table 2
...

The ratio reveals that, although the total amount of interest paid in the most recent year has declined, this is based on a smaller amount of outstanding debt, resulting in a very high interest rate
...

Cautions: A company’s accountants are supposed to create an account for any

discount or premium that investors paid when acquiring its debt, and gradually
amortize these amounts down to zero over the life of the debt; if this entry is not
made, then the reported level of interest will always be the stated interest rate on
the debt, which may not represent the actual interest rate
...
It is also
possible that a company in a difficult financial position has obtained debt at normal market rates, but at the price of severely restrictive covenants that will not appear in the financial statements
...
S
...
The two ratios shown in this section can be used to determine the proportion
of foreign currency gains and losses that a company is incurring in relation to overall net income and sales
...


Asset Utilization Measurements / 23
Formula: Divide both recognized and unrecognized foreign currency gains and

losses by net income
...
This approach gives one a perspective on the size
of such gains and losses in relation to total revenue generating activity
...
Its controller wants to find out
how much of the loss was caused by foreign currency losses
...
Foreign currency losses were $113,000
...
Consequently, the controller will have to continue searching to find additional causes
of the loss
...
In particular, if a large proportion of company
profits comprise exchange gains, an investor should inquire as to why the company is not making more money from its core operating activities
...


24 / Business Ratios and Formulas

OVERHEAD RATE
Description: The overhead rate is used to determine the amount of overhead cost

that should be applied to a unit of production, which may be a completed product
or some amount of services rendered to a customer
...
The following

expenses should be included in overhead:
Depreciation and cost depletion for production-related assets
Factory administration expenses
Indirect labor and production supervisory wages
Indirect materials and supplies
Maintenance
Officers’ salaries related to production services
Production employees’ benefits
Quality control and inspection
Rent
Repair expenses
Rework labor, scrap, and spoilage
Taxes other than income taxes related to production assets
Tools and equipment not capitalized
Utilities
This list of overhead items should be further subdivided into only those portions of the expenses that relate to the production process
...

The activity measure used in the denominator should be a measure that can be
applied broadly to the production process
...
An increasingly
common denominator is total machine hours used
...
13
Allocations
Overhead rate per labor hour
Direct labor hours used
Overhead allocation

Small Overhead Crane
$95
450
$42,750

Automated Loader
$95
125
$11,875

variety of stamping machines and lathes
...
The cost
accountant suspects that this results in the overallocation of costs to some products, and underallocation elsewhere
...
13, which shows the allocation of costs to two products based on a traditional allocation using direct labor hours
...
The
company’s actual labor cost per hour is only $24, so there is almost four times as
much overhead cost charged than direct labor dollars
...

The cost accountant elects to switch to a double allocation method by forming
two cost pools
...
The cost accountant
allocates the labor overhead cost pool using direct labor hours; because the cost
pool is so much smaller than before, the allocation rate will drop to $15
...
The cost accountant allocates the other cost pool based on machine hours
used; because there are thousands of machine hours in a typical month, this allocation rate will also be much smaller, at $28
...
Table 2
...
The net result of this slightly more complex approach is that the
amount of overhead cost charged to the small overhead crane drops significantly,
whereas the overhead charged to the automated loader rises; the change results
from the higher level of machine hours used by the automated loader
...

Cautions: The overhead rate is not generally used anymore for decision-making

purposes, though it is still used to derive the overhead cost that is reported on the
financial statements, per the requirements of Generally Accepted Accounting
Principles (GAAP)
...
14
Small Overhead Crane
Allocations
Overhead rate per unit
Direct labor hours used
Machine hours used
Overhead allocation
Total allocation

Automated Loader

Labor Costs

Machine Costs

Labor Costs

Machine Costs

$15
...
05

$15
...
05

500
$14,025

$7,194

1,120
$31,416

$1,990

$21,219

$33,406

in the direct labor applied to a product will also result in a much larger change in
the amount of overhead cost that is applied to it
...
A properly applied activity-based costing system will avoid this issue by
using a variety of activity measures to determine the most accurate application of
overhead costs
...
If overhead is incurred to reduce the load on the bottleneck, then profits may still increase
despite the increase in expense
...


GOODWILL TO ASSETS RATIO
Description: The Financial Accounting Standards Board no longer requires

companies to amortize the goodwill that is recorded on their balance sheets, preferring instead to have them write down goodwill only after determining that it
has been impaired
...
One can use the goodwill to assets ratio to see if there is an excessive proportion of goodwill on a company’s balance sheet or if the ratio is increasing over time
...
The formula is:

Unamortized goodwill
—————————
Total assets

Asset Utilization Measurements / 27

Table 2
...
However, it has made these acquisitions at a large
premium over the fair market value of the underlying assets
...

The primary group of investors is becoming concerned that there might be a goodwill write-down in the near future
...
15 about the goodwill to assets
ratio for the past five years
...
It appears to be time for the investors to make their concerns known to the
company’s board of directors
...
A company with only a small proportion of goodwill to assets may be just as likely to write down goodwill as a
company that has an overwhelmingly large proportion of it
...
Overhead now composes the largest proportion of costs within this category for many
companies
...
Several variations on this formula are noted in the
following section
...
In order to

get some idea of the changes in this ratio over time, it is important to incorporate
the same costs in the overhead cost pool in every measurement period
...
This approach removes
overhead from the denominator
...

This approach compares overhead to the only direct cost clearly associated with
the manufacturing process (since direct labor is sometimes considered to be a
fixed cost in the short term)
...
This has resulted in a significant reduction in direct
labor costs and an increase in overhead costs
...
She compiles the information
in Table 2
...

The CFO chooses to use the ratio formulation where both direct labor and direct materials are included in the denominator; the results show more than a doubling of overhead costs in proportion to direct costs
...

Cautions: Overhead costs tend to be fixed in the short term, while the mostly di-

rect costs included in the denominator will vary with sales
...
16

Overhead expenses
Direct materials
Direct labor
Overhead to cost of sales ratio

Before Changes

After Changes

$1,458,000
$375,000
$720,000
133%

$2,045,000
$410,000
$302,000
287%

Asset Utilization Measurements / 29

ratio can vary substantially from period to period if sales fluctuate considerably
...
By
doing so, there will be no sharp fluctuations in the denominator, thereby making
the comparison to overhead costs more useful
...

A high ratio of sales to equity and debt indicates a high level of efficiency in creating sales
...

Formula: Divide total sales by the combination of stockholders’ equity and long-

term liabilities
...
The formula is:
Sales
——————————————————
Stockholders’ equity + Long-term liabilities
Example: The CFO of Saint Nick & Elves, purveyors of fine crystal figurines,

has asked a select group of current investors to invest an additional $400,000 in
the company
...
The results
are included in Table 2
...

The turnover ratio is clearly improving over time, which might lead investors
to invest the requested $400,000
...

Cautions: Just because a company has a high investment turnover ratio does not

mean that it can generate a profit
...
17
1999
Sales
Stockholders’ equity
Long-term liabilities
Investment turnover

$13,000,000
$4,250,000
$950,000
2
...
8

2001
$17,250,000
$4,750,000
$640,000
3
...
Consequently, the measure should be combined with an ongoing review of gross margins and net profits
...
It measures the sales level at which a company exactly
breaks even
...
It is also good for determining changes in the break-even point resulting from decisions to add fixed costs
(especially when replacing variable production costs with fixed automation costs)
and figuring changes in profits when the sales staff is contemplating making
changes in product prices
...


Be sure to include all operating costs outside of the cost of goods sold in this calculation—only extraordinary items that are in no way related to ongoing operations should be excluded from this formula, which is:
Total operating expenses
——————————————
Average gross margin percentage
A variation on the formula is to remove all noncash expenses, such as depreciation, from the calculation
...
This formula is:
Total operating expenses – (Depreciation + Amortization + Other
noncash expenses)
———————————————————————————
Average gross margin percentage
Example: The Reef Shark Acquisition Company, which is a holding company

that acquires all types of distressed businesses, is looking into the purchase of a
sewing thread company
...
Its due diligence team constructs the information found in Table 2
...

The table clearly shows that the acquiree currently has a break-even point so
high that it is essentially incapable of ever turning a profit, since the break-even

Asset Utilization Measurements / 31

Table 2
...
However, the removal of
some key overhead costs reduces the break-even point to such an extent that the
acquirer will be able to generate a significant return from the existing sales level
...
The maximum potential profit figure of $750,050 is derived by subtracting the revised break-even
point from the maximum possible sales capacity level of $10,000,000 and then
multiplying the result by the gross profit percentage
...
To calculate it on a spot basis,
it is useful to create a multiperiod measurement, so that an average gross margin
percentage and operating cost can be used that smooths out expense irregularities
over the short term
...
It is particularly useful in situations where large portions of a company’s sales are at risk, such as when they are tied up in a single customer contract that can be cancelled
...

Formula: Subtract the break-even point from the current sales level, and then di-

vide the result by the current sales level
...
This formula can be broken

32 / Business Ratios and Formulas

down into individual product lines for a better view of risk levels within business
units
...
, is contemplating the purchase of

several delivery trucks to assist in the delivery of its Fat Tire Weekly mountainbiking magazine to a new sales region
...
Key information related to this
decision is noted in Table 2
...

The table shows that the margin of safety is reduced from 21% to 19% as a result of the truck acquisition
...

Cautions: This calculation is not of much use in cases where strong seasonal
swings in sales will send the margin soaring far above and plummeting well below
the break-even point on a monthly basis
...

Formula: Divide the income tax paid by the amount of before-tax income
...
The formula is:

Table 2
...
The formula is:
Income tax expense
————————
Before-tax income
Example: The International Outsourcing Group (IOG) conducts manufacturing

operations on behalf of its clients in eleven countries
...
Its primary technique is to shift partially completed products from the United States to Brazil, where they are completed and income is recognized
...

Cautions: None
...
It does not address the measures for operating performance of individual departments, which are covered in Chapters 9
through 13
...
It is designed for use by managers to determine which assets can be safely eliminated from a company without impairing its
operational capabilities
...

Formula: Divide the dollar value of all assets used in the revenue creation process
by the total amount of assets
...
The calculation can also include accounts receivable and inventory
...
The company has recently been acquired by a much younger company that wants to “clean
up shop,” partially by reviewing all assets and clearing out those that are no longer
needed
...
It accumulates the information found in Table 3
...

The acquisition team elects to exclude overdue accounts receivable, obsolete
inventory, and unused production equipment from the numerator in the equation, thereby focusing attention on those items as logical targets for reduction in
order to make Matrix a more asset-efficient organization
...
7% Operating assets ratio
$8,405,000 Total assets
The measurement reveals that about one quarter of Matrix’s assets cannot be
usefully employed for revenue generation and should be evaluated for elimination
...
Unless the measurement is backed up with a rigorous selection system to
determine which assets are truly being used for productive activities, it is likely
that some assets will be included in the numerator that should not be there
...
1
Asset Type
Current accounts receivable
Overdue accounts receivable
Current inventory
Obsolete inventory
Furniture and fixtures
Production equipment
Unused production equipment
Total assets

Gross Value
$428,000
$33,000
$978,000
$524,000
$207,000
$4,832,000
$1,403,000
$8,405,000

Operating Performance Measurements / 37

also require a written justification for the inclusion of specific assets in the numerator of the formula
...
It is particularly noteworthy in cases where a company continually muddies the waters by adding a variety of items, such as asset sales and loss contingency reserves, that make it difficult to see how the underlying business is
performing
...

Formula: Divide operating income by net sales (reduced by investment income)
...
The formula is:
Operating income
——————————————
(Net sales) – (Investment income)
Example: The Misses Sportwear Company, which is publicly held, bothers the

investment analysts who follow its stock because it tends to report consistent earnings for a number of consecutive quarters, followed by an occasional large loss
...
The results are shown in Table 3
...

It is evident from the table that the company is periodically creating a loss reserve, against which it will charge selected operating expense items for the next
few years
...
Operational results, as shown by the sales to operating income ratio, are worsening over time, so
the analyst should issue a sell recommendation on this stock
...
2
2000
Sales
Operating expenses
Operating income
Sales to operating income
Other expenses
Net income/loss

$52,000,000
$58,000,000
-$6,000,000
–11
...
7%
–$9,000,000
+$2,000,000

2002
$58,000,000
$64,000,000
–$8,000,000
–13
...
8%
$20,000,000
–$29,000,000

38 / Business Ratios and Formulas
Cautions: This ratio can cause false signals that a company is having problems,

if the company’s sales are so seasonal that the ratio reveals a loss during nonseasonal selling periods
...
This problem can be avoided by calculating the ratio for each individual product line or
business unit within a company
...
It can also be viewed as the contribution margin before administrative
costs are considered
...
It should be
tracked on a trend line to see if distribution and sales costs are proportionally
changing in relation to sales volume
...
Sales costs should include the sales department’s payroll, commissions, benefits, travel expenses, customer service, field maintenance, warranty,
sales promotion, advertising, and distribution costs
...
It has a gross margin of 40%, but its sales, general, and administrative
costs are so large that the company has never earned more than 2% net profits
...
By breaking sales costs out from other administrative costs and
combining them with the gross margin, the controller finds that the sales margin
drops to only 15%, leaving little room to cover other administrative costs
...
As
a result, the company switches from personalized sales to a furniture catalog, which
completely eliminates travel costs and greatly increases profits
...
This is a very useful measurement, particularly when used to determine the profitability of products or services that are customized to some degree
...


Operating Performance Measurements / 39

GROSS PROFIT PERCENTAGE
Description: This is one of the most important measurements derived from the income statement
...
In essence, it reveals the efficiency of
the production process in relation to the prices and unit volumes at which products
are sold
...
The most common

approach is to add together the costs of overhead, direct materials, and direct
labor; subtract the total from revenue; and then divide the result by revenue
...
The formula is:
Revenue – (Overhead + Direct materials + Direct labor)
———————————————————————
Revenue
The trouble with this approach is that many of the production costs are not truly
variable
...
All other production costs are then
shifted into other operational and administrative costs, which typically yields a
high gross margin percentage
...
Recently, the Iberian Tile Company has been taking business away from the Spanish Tile Company through more aggressive pricing
...
This
means that its competitor is always in a position to offer lower prices, because it
does not incorporate direct labor and overhead costs into its pricing model
...
If a prospective sale requires
a great deal of kiln time, then it is charged a much higher price than other quotes
that do not use as much of this valuable resource
...

Cautions: As was hinted at in the example, a company can incorrectly assume

that all of the costs used to calculate the gross margin are variable
...
Consequently, changes in sales volume will generally result in a different gross margin
percentage, since some of the costs vary with the sales volume and others (e
...
, direct labor and overhead) are fixed
...
If the ratio is substantially higher than one, then there is a high risk
that fraudulent reporting was used to achieve an improvement in the gross profit
percentage from period to period
...
The formula is:
Gross profit in period two
———————————
Sales in period two
———————————
Gross profit in period one
———————————
Sales in period one
Example: The internal auditor of the Ultra-Kleen Carpet Company, makers of

easy-to-clean throw rugs, has maintained a gross profit index calculation on a
monthly basis for a number of years, so that potential accounting irregularities can
be spotted shortly after they arise
...
3
...
3

Sales
Gross
margin
Gross
profit %
Gross profit
index

Jan

Feb

Mar

Apr

May

Jun

$2,500,000

$2,400,000

$2,550,000

$2,650,000

$2,300,000

$2,450,000

$1,050,000

$984,000

$1,096,500

$1,298,500

$1,150,000

$1,200,500

42%

41%

43%

49%

50%

49%

—

98%

105%

114%

102%

98%

Operating Performance Measurements / 41

The gross profit index unaccountably increased to 114% in April, which reflects a jump in the gross profit percentage from 43% to 49% from March to
April
...
With this clue, the internal auditor digs deeper into the issue and
eventually finds that sales have been improperly booked for many months beginning in April, resulting in inordinately large gross margins
...
For example, if a manufacturing company with 30% gross margins were to purchase a software company with 95%
gross margins, the gross profit index would vary enormously, but would be entirely valid
...
For example, a change in the allocation method for overhead costs between periods would alter the gross margin to
such an extent that the periods would not be comparable
...
However, review the Cautions section in regard to the how
this measure can skew a company’s investment objectives
...
The dividend and interest income should be recorded on the accrual basis, since there may be timing differences in the receipt of funds that would otherwise shift the income to some future
period and skew the resulting measurement
...
However, this entry does not necessarily correspond to an actual cash payment to the investor, either at the time of the entry or
at any point in the future, and for that reason may be excluded from the calculation
...
The CFO would

42 / Business Ratios and Formulas

Table 3
...
S
...
5%
4
...
5%
12
...
1%

like to determine the average investment income percentage from these investments
...
4
...
All other funds are invested on a long-term basis with a balanced goal of
modest risk and return
...
1% is reasonable
...
In reality,
most companies reserve some portion of their available funds for extremely safe
and liquid investments that yield low returns
...
To ensure that the use of
this measurement does not result in improper investments, it should be coupled
with an ongoing review of the risk ratings of the investments
...

A separate issue is that companies may invest some excess funds in whole life
insurance policies, which can have significant cash surrender values
...


OPERATING PROFIT PERCENTAGE
Description: The operating profit percentage reveals the return from standard op-

erations, excluding the impact of extraordinary items and other comprehensive income
...


Operating Performance Measurements / 43
Formula: Subtract the cost of goods sold, as well as all sales, general, and ad-

ministrative expenses, from sales
...
Expense totals used in the ratio should exclude
all extraordinary transactions, as well as asset dispositions, since they do not relate
to continuing operations
...
In the current month, it will incur an operating loss of $15,000, which will allow the bank
to call in its loan
...
To be ethically correct, the controller also specifies the exact contents of
the calculation in the next report to the bank
...
Examples of possible methods for altering this ratio
are incorrect capitalization of expenses, recording expenses in the wrong accounting
periods, and inaccurately valuing inventories
...
The number of methods for falsely enhancing this ratio is enormous
...
It is

44 / Business Ratios and Formulas

particularly useful when a company is considering the acquisition of more fixed
assets to replace variable costs, such as manual labor in the production process,
and wants to find out the extent to which this will add to its fixed cost structure
...

Formula: Subtract all variable expenses from sales and then divide this amount

by operating income
...
The formula is:
Sales – Variable expenses
———————————
Operating income
Example: The Wide Wallet Company, maker of fine wallets to be sold in coun-

tries issuing large banknotes, is considering the services of an outsourcing company to sew its wallets, thus dispensing with a number of personnel on its
production line
...
5
...
The outsourcing contract has a minimum fixed cost of $580,000, which can
be increased if production levels exceed a contractually set minimum level
...
Consequently, the proposed deal
is dropped
...

Though all costs are variable in the long term, most are hard to change in the short
term and so should be itemized as fixed costs
...
5
Before Outsourcing
Sales
Fixed outsourcing fee
Direct labor cost
Direct materials
Operating income
Operating leverage ratio

$3,750,000
$0
$1,450,000
$800,000
$150,000
10:1

After Outsourcing
$3,750,000
$580,000
$850,000
$800,000
$170,000
12:1

Operating Performance Measurements / 45

personnel are usually not variable, since most companies do not vary their direct
labor staffing levels unless there are marked changes in the level of production
...
This figure is the one most commonly used as a
benchmark for determining a company’s performance, even though it can be significantly misrepresented by the accounting department, as noted in the Cautions
section below
...
If this percentage is being tracked on a

trend line, it may be useful to eliminate from the calculation any extraordinary income items, such as losses from disasters, since they do not yield comparable period-to-period information
...
This involves an investment of about
$200,000 per hair salon
...
To do so, it sets the
capitalization limit very low, at just $250, so that nearly everything it purchases is
capitalized
...
Its operating results
for a typical store are shown in Table 3
...

The key line item in the table is the assets costing less than $1,000; if the company had set a higher capitalization limit, these costs would have been recognized
as expenses at once, which would have yielded a loss on operations of $27,000 per
store
...
When

Table 3
...

Cautions: The net income figure is frequently taken as representing a company’s

operational performance, even though it can be warped by the inclusion of interest income and expense (which are financing activities) plus the inclusion of gains
and losses from nonoperating activities
...

Consequently, an initially favorable opinion of a company’s performance from reviewing this percentage should be bolstered by the examination of other measures
to ensure that it has indeed had favorable financial results
...
It is least useful in highly automated entities where
the proportion of labor costs to total costs is quite small
...

Formula: Divide net profit by the total number of full-time equivalents
...
A full-time equivalent (FTE) is the combination of staffing that equals a 40-hour week
...
The formula is:
Net profit
———————————————
Total full-time equivalents
Example: The Durable Diskette Company’s president is considering a new bonus

plan for the management team that is based on the number of personnel in relation
to profits
...
Some managers will attempt to incorrectly enhance their reported performance under this measure, so the
president derives a formula that converts the cost of part-time staff, outsourced
services, and services from temporary agencies into FTE
...

The total of all hours recorded in the payroll system per month divided by 160
hours equals the number of FTEs on hourly pay
...

The total billings from outsourcing services per month divided by the hourly
cost of equivalent positions within the company or industry equals the total
number of FTEs from outsourced functions
...

Cautions: In a very-low-profit situation, this ratio is so small that it yields no rel-

evant information
...


4
Cash Flow Measurements

T

hough many of the other ratios in this book are useful for determining a company’s performance level in a variety of areas, the core issue is whether there
is enough cash flowing from ongoing operations to sustain the company
...

If a performance measure in this chapter yields a poor result, then action must be
taken at once to ensure that corporate survival is maintained
...
The cash
flow measures in this chapter are:
Cash Flow from Operations
Cash Flow Return on Sales
Fixed Charge Coverage
Expense Coverage Days
Cash Flow Coverage Ratio
Cash Receipts to Billed Sales and
Progress Payments
Cash to Current Assets Ratio
Cash Flow to Fixed Asset
Requirements

Cash Flow Return on Assets
Cash to Working Capital Ratio
Cash Reinvestment Ratio
Cash to Current Liabilities Ratio
Cash Flow to Debt Ratio
Stock Price to Cash Flow Ratio
Dividend Payout Ratio

CASH FLOW FROM OPERATIONS
Description: Under generally accepted accounting principles, a company can eas-

ily report a large income figure, even while its cash reserves are draining away
...

Any difference in the ratio that varies significantly from one is indicative of substantial noncash expenses or sales in the reported income figures
...


49

50 / Business Ratios and Formulas
Formula: The formula can be generated in two formats
...
The
first format yields a more accurate view of the proportion of cash being spun off
from ongoing operations, whereas the second version shows the impact of any
transactions that are unrelated to operations
...
, grabs the same spots
...
However, it cannot understand why its bank continues to refuse additional loans to fund ongoing operational needs
...
The company’s relevant projections are
shown in Table 4
...

The table reveals the key problem for BBIC, which is that the company is recognizing insurance as revenue prior to the receipt of cash from policy holders in
some cases
...

The bank correctly finds this ratio to be indicative of BBIC’s future inability to
pay back a loan and so refuses to extend one
...
The variance can be caused by significant and prolonged cash
flow problems, or perhaps only a short-term issue that will not reappear, and there
is no way to know unless one peruses the statement of cash flows for more detail
...


Table 4
...
It will tend to fluctuate in accordance with a company’s step costs
...
If it were to increase its costs in order to add capacity, the resulting cash flow could very well drop until sales increase to the point where incremental cash inflows exceed the incremental cash outflows associated with
added production capacity
...
This ratio is more useful when it is

subdivided into individual product lines, so managers can see which products are
generating the most cash flow relative to sales volume
...
The CFO decides to split the company into its various product lines
to determine where the cash flow problems are the worst and organizes the information for Table 4
...

The table reveals that only the Norwegian product line is generating a positive
cash flow return on sales
...
The CFO fires the controller and sets up better controls over the
recording of sales
...
Also, it
may not make sense to pour more resources into a product line that generates a high
ratio of cash flow return on sales if that product line has already achieved its maximum market share potential
...
2

Sales
Net income
Noncash expenses
Noncash sales
Cash flow return on sales

Andalusian Line

Norwegian Line

Tasmanian Line

$4,025,000
$55,000
$123,000
$383,000
–5%

$1,750,000
$128,000
$58,000
$0
+11%

$850,000
$89,000
$32,000
$248,000
–15%

52 / Business Ratios and Formulas

product lines that could achieve greater cash flow returns if the proper investment
were made in them now
...
The fixed charge coverage ratio can be used
to see if this is the case
...
A ratio close to one reveals that a
company must use nearly all of its cash flows to cover fixed costs and is a strong
indicator of future problems if sales drop to any extent
...

Formula: Summarize all fixed expenses, leases, and principal payments for the

year, and divide them by the cash flow from operations
...
The types of expenses and other payments that
are fixed can be subject to some interpretation; for example, if a lease is close to
expiring, there is no need to include it in the formula since it is a forward-looking
measure, and there will be no lease payments in the future
...
The formula is:
Fixed expenses + Fixed payments
——————————————
Cash flow from operations
Example: The owner of Dinky Dinosaur Toys is anticipating a slowdown in the

sales of his high-end wooden toys in the upcoming year and wants to know what
his company’s exposure will be
...
However, there are some
line items on the list that are open to interpretation
...
Second, the expected lease on the company car is
not really a fixed cost since it has not yet been incurred and can be stopped at the
owner’s option
...
Another issue is
the interest on the line of credit: most lines of credit require a complete payoff at
least once a year, which means that this line can theoretically be zero
...
Consequently, there
is considerable room for judgment regarding the inclusion or exclusion of items
that are highly dependent upon the purposes of this ratio and deciding what constitutes a “fixed” charge
...
Also, an increasing number
of costs may be considered fixed in the short term, whereas nearly all costs can be
considered variable if a sufficiently long time frame is used
...
However, if the period is extended to more than a year, it is
possible that even some loan payments can be successfully accelerated and completed during the intervening period, thereby eliminating them from the fixed
charge list
...


EXPENSE COVERAGE DAYS
Description: This calculation yields the number of days that a company can cover

its ongoing expenditures with existing liquid assets
...
The calculation is also useful for seeing if there is an excessive
amount of liquid assets on hand, which could lead to a decision to pay down debt
or buy back stock, rather than keep the assets on hand
...
Then di-

vide the result into the summary of all assets that can be easily converted into cash
...
However, if all of these additional expenses were to be stripped out
of the calculation, the ratio would always be incorrect, for there will inevitably be
some unusual expenditures
...

Companies experiencing rapid changes in expenditure levels will not have this option, and so will have to make judgment calls regarding the most appropriate expenditures to include in the calculation
...
The CDC president is concerned that the government has not
yet approved the budget for the upcoming year and cannot release funds to CDC
until the date of approval
...
The controller finds that total
expenditures in the preceding 12-month period were $7,450,000
...
3
...
8 Days of expense coverage
Cautions: This calculation only reveals the number of days over which expenses
can be paid if no other operational decisions are made
...
3
Fund Type
Cash
Short-term marketable securities
Accounts receivable
Total

Amount
$48,500
$425,000
$620,000
$1,093,500

Cash Flow Measurements / 55

lengthen the ratio
...
The ratio
can also be misleading if the annual expenditure level used to determine the denominator does not reflect the expense level being incurred during the period covered by the ratio (typically the next few months)
...
Consequently, the results of this calculation must be viewed in the
context of the current state of accounts payable and short-term expenditure levels
...
This variation focuses attention on the ability of a company’s cash flow to
cover all nonexpense items, which include payments for the principal on debt, dividends, and capital expenditures
...

Formula: Summarize for the reporting period all principal payments (including

the principal portion of capital lease payments) as well as dividend payments and
capital expenditures
...
The formula is:
Total debt payments + Dividend payments + Capital expenditures
———————————————————————————
Net income + Noncash expenses – Noncash sales
Example: The CFO of the rapidly expanding Perpetual Motor Company wants to

make sure that there is enough cash flow to cover the company’s debt and capital
expenditure payments for the upcoming year
...
There are no planned dividend payments
...

Cautions: The measure may be misleading in cases where a company has an up-

coming balloon payment on its debt, since the measure is historical in nature and
will not show the upcoming principal payback requirement
...
The same
problem arises in the case of capital expenditures since the historical pattern of expenditures may not resemble upcoming capital expenditure requirements; once
again, the problem can be resolved by including expected capital expenditures in
the denominator
...
It is most useful when compared to the number of days of accounts
receivable outstanding, because this measure may reveal that not all cash is being
collected at the same time that the days of receivables calculation may be low,
which indicates that the collections staff is writing off a considerable proportion
of receivables rather than going to the effort of collecting them
...
Credit card sales should be included on both sides of the formula, since there is no question that cash will be collected on them
...
To test the validity of this claim, the CFO asks the programming staff to create a program that matches cash receipts to all billed items;
this comparison of cash receipts to billed sales yields a significantly worse result
than claimed by the collections manager
...
The CFO fires the collections manager and decides to measure
the performance of the next collections manager with the cash receipts to billed
sales ratio
...
The in-

formation in the denominator is simple enough to obtain, but the cash receipts figure must be derived from a precise review of actual receipts from each billing,
which can be a labor-intensive process
...


CASH TO CURRENT ASSETS RATIO
Description: The cash to current assets ratio is useful for determining the pro-

portion of cash within the current assets category
...
It is most useful for determining the ability of a
company to pay off liabilities in the extremely short term
...
Current assets include cash, short-term marketable securities, accounts receivable, and inventory
...
A potential investor is concerned that many of the assets of these two categories will
never be converted into cash
...
6% Cash to current assets ratio
The ratio reveals that the company is having a very difficult time converting its
inventory and accounts receivable into cash
...

Cautions: The amount of cash and short-term marketable securities on hand can

vary significantly by day, given the need for payments to cover check runs and
payrolls
...
If it is being measured on a trend line, then an alternative is to
calculate it for the same date within each month (presumably the last day), when
the short-term impact of check runs and payrolls will be similar from month to
month
...
If the ratio indicates
a cash shortfall, then a company must either curtail its asset-purchasing expectations or go to an outside source for additional funding
...
The basic formula is:
Net income + Noncash expenses – Noncash sales
————————————————————
Budgeted fixed asset purchases
The formula can be expanded to include other nonexpense payments, such as dividends and principal payments on loans, to gain a more accurate picture of a company’s ability to purchase fixed assets
...
The owner has no need to distribute dividends, but must
make principal payments on amusement equipment purchased in previous years
...
4
...
4
Fund Type

Amount

Net income
Depreciation
Principal payments
Budgeted fixed asset purchases

$725,000
$125,000
$350,000
$800,000

Based on this information, the ratio calculation is:
Net income + Noncash expenses – Principal payments
——————————————————————— =
Budgeted fixed asset purchases
$725,000 + $125,000 – $350,000
—————————————— =
$800,000
$500,000
———— =
$800,000
62
...

Cautions: Cash flows can be altered by the presence of one-time expenses, some

of which will appear in a company’s financial statements from time to time
...
Also, if the ratio results in a figure close to 100%, management
may want to arrange for a line of credit even if the amount of cash flow is sufficient, to leave itself with a reserve source of cash to cover contingencies
...
It can be used as a substitute for
the popular return on assets measure, since the net income figure used in the return
on assets calculation is subject to greater manipulation through the use of noncash
accounting entries
...
Then subtract from this amount any noncash sales, such as
revenue that has been recognized but is unbilled
...
The formula is:

60 / Business Ratios and Formulas

Net income + Noncash expenses – Noncash sales
————————————————————
Total assets
Example: The president of the Glowering Tail Light Company, resellers of
1950s-era tail lights, has been told by the controller for several years that the company has a sterling return on assets
...
5
...
To arrive at the
cash flow return on assets, the president must add back the noncash depreciation
expense and then subtract a series of noncash accounting entries that have
artificially increased the revenue level
...
8% Cash flow return on assets
Though the cash flow return on assets percentage is acceptable, it is also considerably less than the reported return on assets
...
Though the intent of the measure is precisely this kind of
behavior, it can also result in old assets not being replaced in a timely manner,
which may cause capacity shortfalls when equipment fails
...
5
Return on Assets
Net income
Depreciation
Pension fund gains
Bill and hold revenue
Percentage of completion revenue
Total assets
Measurement

$1,000,000

$3,250,000
30
...
8%

Cash Flow Measurements / 61

they may not want to invest in untried equipment or new products that will require
large investments with an uncertain payoff
...

If the ratio is low, it may be an indication that a company will have trouble meeting its short-term commitments because of a lack of cash
...

Formula: Add together the current cash balance as well as any marketable secu-

rities that can be liquidated in the short term, and divide the total by current assets
less current liabilities
...
The formula is:
Cash + Short-term marketable securities
—————————————————
Current assets – Current liabilities
Example: The Arbor Valley Tree Company has a large inventory of potted plants
and trees on hand, which comprises a large proportion of its inventory and is
recorded as part of current assets
...
The company’s financial analyst wants to know what proportion
of the current ratio is really composed of cash or cash equivalents, since it appears
that a large part of working capital is skewed in the direction of this slow-moving
inventory
...
6
...
6
Fund Type

Amount

Liquidity

Cash
Money market funds
Officer loan
Accounts receivable
Inventory
Current liabilities

$55,000
$180,000
$200,000
$450,000
$850,000
$450,000

Immediately available
Available in one day
Due in 90 days
Due in 45 days
Turnover every 4 months
Due in 30 days

62 / Business Ratios and Formulas

Cash + Short-term marketable securities
————————————————— =
Current assets – Current liabilities
$55,000 + $180,000
————————————————————————————— =
($55,000 + $180,000 + $200,000 +$450,000 + $850,000) – ($450,000)
$235,000
————— =
$1,285,000
18%
The financial analyst did not include the note receivable from the company officer, since it would be available for 90 days
...

Cautions: This measurement can be considerably skewed by the timing of the

measurement within the reporting period
...
In these situations, the measurement will drop precipitously
right after the payment event, making the company cash situation look much
worse than it really is
...
This can be indicative of a
strong commitment by the owners to build the business
...

Formula: To calculate the ratio, summarize cash flow for the period, subtract any

dividends paid, and then divide the result by the combined incremental increase in
both fixed assets and working capital
...
An alternative calculation is to eliminate changes
in working capital from the numerator, which allows one to focus on the key investments being made in a company’s plant and equipment
...
It is in a growth industry, and a high rate of reinvestment is
expected
...
The
investor should closely question the management team regarding their perceived
slow rate of internal asset growth
...
To see if the underlying issue is related to
mismanagement, calculate the ratio of fixed assets to revenue, and see how this
correlates to the same ratio for other businesses in the same industry
...
If these ratios indicate unusually high proportions of assets or working capital within the business,
then there is either some mismanagement of assets or the company’s operational structure is so different from other businesses that their results are not
comparable
...
A healthy cash situation is one in which the
measurement’s result is significantly higher than 100%
...
If there are also marketable securities that cannot be liquidated for some time, then the deciding factor for whether to include them in the
numerator is if their earliest possible liquidation date is equal to or less than the
dates at which the current liabilities must be paid
...
7

Cash
Short-term marketable securities
Current liabilities
Cash to current liabilities ratio

Quarter 1

Quarter 2

Quarter 3

$120,000
$82,000
$418,000
48%

$225,000
$61,000
$682,000
42%

$288,000
$50,000
$914,000
37%

Cash + Short-term marketable securities
—————————————————
Current liabilities
Example: The Video Café Store, a rapidly expanding coffee bar that sells televi-

sions to its drinkers, has had continuing problems with cash flow for a number of
years
...

Table 4
...

The measurement for any of the three quarters indicates a considerable cash
shortage, with a trend line that indicates a worsening problem
...
Based on this information, the
CFO schedules a discussion with the executive team to discuss a reduction in the
rate of growth
...
For example, a company that pays its employees
once a month will presumably do so on the last day of the month, based on work
performed during that month
...
Nonetheless, the measurement ignores this key
expense item, which can mislead one into thinking that a company can easily
cover its liabilities with existing cash, when in reality its unreported liabilities may
far exceed the amount of cash available
...
A ratio well above one is a sign of
having not only enough cash to meet debt payment needs but also of sustaining
more debt obligations, if necessary
...
Keep in mind that the interest ex-

Cash Flow Measurements / 65

pense associated with the debt has probably already been included in the derivation of the net income figure that is part of cash flow, so do not include it again in
the denominator part of the ratio
...
This version of the ratio is:
Net income + Noncash expenses – Noncash sales
—————————————————————
Total long-term debt payments for the period
Example: The Saba Exploratory Consortium has requested a loan from the First

Bank of the U
...
Virgin Islands so that it can purchase another deep sea submersible for the laying of underwater phone cables
...
8, which has
financial information for the last three years
...
The
bank may want to consider granting a loan with a short payback period so that it
can get its money out quickly, before the ratio worsens further
...
Also, the ratio may be rendered irrelevant if there is a sudden increase
in the level of debt acquired in the future, perhaps due to an aggressive acquisition
or capital budgeting expansion
...


Table 4
...
7:1

$12,250,000
$4,750,000
$150,000
2
...
2:1

66 / Business Ratios and Formulas

STOCK PRICE TO CASH FLOW RATIO
Description: One way in which investors can value a company is by the amount

of cash flow it generates
...
The ratio may also be used
to determine the stock price that a company will probably achieve if it can reach
a specific level of cash flow
...
The stock price and number of shares outstanding should be averages for the period over which the cash flow was generated
...
The phone service provider industry, in which the Audible Phone Company
operates, has a long history of generating a stock price to cash flow ratio of 6:1
...
There are currently 13,750,000
shares outstanding
...
If there are future expectations of unusually high or low sales volume, then
investors will bid the stock to correspondingly high or low levels that may have
nothing to do with the stock price to cash flow ratio
...


Cash Flow Measurements / 67

DIVIDEND PAYOUT RATIO
Description: This ratio is used by investors to see if a company is generating a

sufficient level of cash flow to assure a continued stream of dividends to them
...

Formula: Divide total annual dividend payments by annual cash flow
...
The formula is:
Total dividend payments
————————————————————
Net income + Noncash expenses – Noncash sales
Example: The Williams Fund is a major investor in the Continental Gas and

Electric Company
...
The
family is concerned that electricity deregulation may be impacting the ability of
Continental Gas to pay dividends
...
9
...
At the current
pace of cash flow decline, Continental will be unable to support its current dividend rate in less than two years
...
A better approach, as was used in the example,
is to run a trend line on the ratio for several years to see if a general pattern of decline emerges
...
9

Total dividend
Cash flow
Dividend payout ratio

2002

2003

$43,000,000
$215,000,000
5:1

$45,000,000
$180,000,000
4:1

2004
$48,000,000
$144,000,000
3:1

5
Liquidity Measurements

T

his chapter is filled with measurements that are of considerable use to lenders,
investors, and investment analysts
...
This is accomplished by examining a company’s ability to collect
accounts receivable in an efficient manner, use its inventory within a short time
frame, pay its accounts payable when due, and maintain a sufficient amount of liquid funds to pay off short-term liabilities
...
A very high level of accounts receivable turnover indicates that a
company’s credit and collections function is very good at avoiding potentially
delinquent customers, as well as collecting overdue funds
...
The key issue in this calculation is the concept
of annualized credit sales
...
A better approach is to simply multiply the current month’s
sales by 12 to derive the annualized credit sales figure
...
The exact measurement method
used can result in some variation in the reported level of turnover, so one should
model the results using several different approaches to arrive at the one that most
closely approximates reality
...
The management team needs to conserve cash and decides to review accounts receivable to see if this might be a likely source
...
1
...
If the turnover rate had remained the same as one year
ago, the amount of accounts receivable outstanding would have been $3,562,500,
which is derived by dividing annualized sales of $28,500,000 by turnover of eight
...
Based on
this information, the management team decides to tighten credit policies, purchase collection software, and add more collections staff
...
However, these packages use a different calcu-

Table 5
...
This method works fine, but only if the calculation is a weighted average
that is based on the amount of each receivable
...


AVERAGE RECEIVABLE COLLECTION PERIOD
Description: Some people find that the accounts receivable turnover figure is

easier to understand if it is expressed in terms of the average number of days that
accounts receivable are outstanding
...
For example, if the average collection period is 60 days and the standard days of credit
is 30, then customers are taking much too long to pay their invoices
...

Formula: Divide annual credit sales by 365 days, and divide the result into aver-

age accounts receivable
...
In the June accounting period, the beginning accounts receivable balance was $318,000, and the ending balance was $383,000
...
Based on this information, the controller calculates the
average receivable collection period as:
Average accounts receivable
———————————— =
Annual Sales / 365
($318,000 Beginning receivables + $383,000 Ending receivables) / 2
———————————————————————————— =
($625,000 × 6) / 365
$350,500 Average accounts receivable
———————————————— =
$10,273 Sales per day
34
...
Since the
company has a stated due date of 30 days after the billing date, the 34
...


72 / Business Ratios and Formulas
Cautions: The main issue is what figure to use for annual sales
...
This problem is especially common when sales are highly seasonal
...


DAYS DELINQUENT SALES OUTSTANDING
Description: There is no collection problem with the vast majority of accounts re-

ceivable
...
The days delinquent sales outstanding measure is
an effective way to use this, since it only addresses those invoices that are overdue
...
The formula is:

(

)

Annualized credit sales from deliquent accounts
———————————————————— ÷ 365
Average delinquent accounts receivable

Example: The Clean Carburetor Company (CCC) sells its product to several spe-

cialty engine manufacturers, some of whom are being squeezed on prices by the
major car manufacturers, and so pay their bills late
...
The first
step in this process is to measure the days of delinquent sales outstanding
...
With this information, the collections manager uses the following formula to arrive at the ratio:
365
Annualized credit sales from delinquent accounts
———————————————————— =
Average delinquent accounts receivable
365 Days
$4,350,000 Annualized credit sales from delinquent accounts
————————————————————————— =
$815,000 Average delinquent accounts receivable
68
...
For example, if the allowable
payment period for an invoice is 30 days, most customers will pay the bill on the
30th day, so it will not arrive by mail for several more days
...
There is no
standard approach to determining the cutoff point, but it is reasonable to allow up
to a week of extra time beyond the allowed payment period before classifying an
invoice as delinquent
...
If the subject company is small, it is likely that
there are only a few delinquent invoices, so the collection of just a few of them will
significantly alter the average amount; this is less of an issue for large companies,
where there are so many more outstanding invoices that the collection of one or two
will not have a significant impact on the average amount outstanding
...
When the ratio increases over the preceding period (e
...
, is
greater than one), it is possible that a company is reporting false sales figures in
order to buoy its reported level of profitability
...
The underlying concept for the index is that the offsetting entry to a false sale will be accounts receivable, which will therefore increase, since there is no way that the false
receivable can be collected and converted into cash
...

Formula: Divide the sales in period two (the most recent period) by accounts re-

ceivable for the same period
...
The formula
is:
Accounts receivable in period two
————————————————
Sales in period two
————————————————
Accounts receivable in period one
——————————————
Sales in period one
Example: The management of the Optico Fiber Company, a publicly held manu-

facturer of fiber cables and connection equipment, is suspicious of a sudden rise

74 / Business Ratios and Formulas

Table 5
...
They bring in a fraud auditor,
who compiles information for all four quarters of the year, shown in Table 5
...

There is no ratio calculation for the first quarter, since there is no preceding period against which a comparison can be made
...
This is reasonable grounds for
suspecting fraud, so the management team authorizes a more in-depth analysis of
the situation
...
For example, if a company loosens its credit
policy, it is likely that the amount of accounts receivable in relation to sales will
increase
...


ACCOUNTS RECEIVABLE INVESTMENT
Description: The accounts receivable investment calculation is useful for deter-

mining the cost of maintaining a company’s accounts receivable balance
...

Formula: Divide the average days taken by customers to pay their accounts

payable (as described earlier in this chapter in the Average Receivable Collection
Period section) by 365 days, in order to determine the fraction of a year that accounts receivable are outstanding
...
Then subtract from this figure the average gross margin on products
sold, which yields the average cost of goods sold that has not yet been collected
...
This results in the investment cost to the

Liquidity Measurements / 75

company of not collecting the cost of goods sold portion of the accounts receivable
...
The CFO wants to bring this issue to the president’s attention
by using the accounts receivable investment calculation
...
In addition, the company has annual credit sales of $14,250,000, an
average gross margin of 35%, and a cost of capital of 14
...
The CFO calculates
the measurement as:
72 Days to payment
———————— × $14,250,000 Sales × (1 – Margin %) ×
360 Days
(14
...
The calculation is:
38 Days to payment
———————— × $14,250,000 Sales × (1 – Margin %) ×
360 Days
(14
...
To see if the company
has lost money by using this credit policy, the CFO should also determine the incremental increase in gross margin that was brought about by the looser credit policy
...

Cautions: The annual credit sales portion of the calculation may need to be ad-

justed to reflect the annualized amount of sales at the time of the measurement
rather than the estimated amount of sales for the full year
...

Also, the gross margin deduction may be excluded from the calculation, since
it focuses attention only on the cost of capital associated with the uncollected cost
of goods sold
...

Finally, the incremental rate of investment income rather than the corporate
cost of capital can be used, because this more appropriately reflects the incremental amount of income to the company that is being lost when an account receivable
is not collected
...
This ratio yields information that is used to determine how much
cash will be invested in accounts receivable at that time, which is crucial for such
activities as fund-raising, investment activities, and payables planning
...
Then multiply this daily
sales amount by the average accounts receivable collection period (as calculated
earlier in this chapter’s Average Receivable Collection Period
...
The company’s CFO is concerned about running out of cash, because the firm’s rapid growth is requiring a
great deal of cash to support its working capital needs
...
The month has 28 days, the sales forecast
for the period is $418,000, and the average collection period is 39 days
...
In reality, many companies

Liquidity Measurements / 77

frantically ship products to customers during the last few days of the month to
empty the backlog for the first few weeks of the next month
...
The problem also
arises in services businesses, which frequently bill their customers at the end of the
month, based on hours worked for the entire month
...
Consequently, it is common
to see significant incoming cash flows from accounts receivable either just before
or after the month-end
...


INVENTORY TO SALES RATIO
Description: This calculation is used to determine the amount of inventory that is

kept on hand to support a specific level of sales
...
It can also be used as a substitute for the inventory turnover calculation,
which compares inventory to the cost of goods sold instead of sales
...

Formula: Divide annualized sales by total inventory
...
The formula is:
Sales
————
Inventory
Example: The controller of the Shapiro Pool Company suspects that a series of

poor purchasing decisions over the years has led to the accumulation of a large
number of obsolete items in its massive inventory of pool supplies
...
3:

Table 5
...
5:1

$8,475,000
$2,119,000
4:1

78 / Business Ratios and Formulas

The ratio shows a gradual decline over the past three years, thereby proving the
theory
...

Cautions: A seasonal business may have inventory levels that fluctuate dramati-

cally over the course of a year, with a gradual increase in inventory up to the prime
selling season, followed by a dramatic drop-off in inventory levels immediately
thereafter
...


INVENTORY TURNOVER
Description: Inventory is frequently the largest component of a company’s work-

ing capital; in such situations, if inventory is not being used up by operations at a
reasonable pace, then the company has invested a large part of its cash in an asset
that may be difficult to liquidate in short order
...
This section describes several variations on the inventory turnover measurement, which
may be combined to yield the most complete turnover reporting for management
to peruse
...

Formula: The most simple turnover calculation is to divide the period-end in-

ventory into the annualized cost of sales
...
The formula is:
Cost of goods sold
————————
Inventory
A variation on the preceding formula is to divide it by 365 days, which yields
the number of days of inventory on hand
...
5 inventory turns, even though they represent the same situation
...
However, only direct
material costs directly relate to the level of raw materials inventory
...
This measurement can also be divided into 365 days to yield the number of days of raw materials on hand
...
However,
if these added costs can be stripped out of the work-in-process and finished goods
valuations, then there are reasonable grounds for comparing them to the direct materials expense as a valid ratio
...
The information the CFO had is shown in Table 5
...

To calculate total inventory turnover, the CFO creates the following calculation:
Cost of goods sold
———————— =
Inventory
$4,075,000 Cost of goods sold
————————————— =
$815,000 Inventory
5 Turns per year
To determine the number of days of inventory on hand, the CFO divides the
number of turns per year into 365 days:

Table 5
...
One result that is probably not good in any industry is that the comparison of direct materials to raw materials inventory yielded only four turns per year
...

Cautions: The turnover ratio can be skewed by changes in the underlying costing
methods used to allocate direct labor and especially overhead cost pools to the inventory
...
The ratio can also become skewed if the
method of allocating costs is changed; for example, it may be shifted from an allocation based on labor hours to one based on machine hours, which can alter the
total amount of overhead costs assigned to inventory
...
In all three cases, the amount of inventory on hand has not changed,
but the costing systems used have altered the reported level of inventory costs,
which impacts the reported level of turnover
...
Accordingly, the measurement can be subdivided so that there are separate calculations for raw materials, work-in-process,
and finished goods (perhaps subdivided further by location)
...


Liquidity Measurements / 81

INVENTORY TO WORKING CAPITAL RATIO
Description: Inventory can be a large component of working capital—so large

that it skews the perception of a company’s ability to raise cash from working capital, especially if the inventory has a slow rate of turnover and/or contains a high
proportion of obsolete inventory
...

Formula: Divide inventory by working capital, which can be defined as current

assets minus current liabilities or as accounts receivable plus inventory minus accounts payable
...
The bank is
not familiar with this company’s business or its ability to generate sufficient cash
to pay back the loan
...
5 from the
company
...
The bank investigates further and finds that the inventory turnover rate has been declining over the three years measured
...

Cautions: This measurement should be accompanied by an inventory turnover

calculation, since a company may still be relatively liquid even with a high proportion of inventory to working capital, as long as the inventory turns over so
rapidly that converting it to cash is not a problem
...


Table 5
...
This is useful in determining
a company’s ability to generate sufficient cash to meet upcoming liabilities
...
Then multiply the inventory balance by the average number
of days required to liquidate it (which includes both the number of days to sell the
inventory and the number of days to collect the resulting accounts receivable)
...
If the accounts receivable or inventory balances tend to
fluctuate significantly, an average figure can be used for both
...
The controller reports that the company has $382,000 of accounts receivable, which typically require 47 days to liquidate
...
With this information, the president calculates the liquidity index as:

(Accounts receivable × Days to liquidate) + (Inventory × Days to liquidate)
——————————————————————————————— =
Accounts receivable + Inventory
($382,000 Receivables × 47 Days to liquidate) + ($712,000 Inventory ×
107 Days to liquidate)
—————————————————————————————— =
$382,000 Receivables + $712,000 Inventory
86 Days to convert accounts receivable and inventory into cash
Note that the number of days to liquidate the inventory is not 60 days, as would
be indicated by the six inventory turns per year, but rather 107 days, which includes the additional 47 days to collect the accounts receivable into which the inventory will be converted once it is sold
...

Cautions: The chief difficulty with the liquidity index is that it is based on aver-

age collection periods, and so does not yield a great deal of precision in regard to
the exact amount of cash that will be available on a certain day
...


ACCOUNTS PAYABLE DAYS
Description: A calculation of the days of accounts payable gives an outside ob-

server a fair indication of a company’s ability to pay its bills on time
...
Alternatively, a small number of accounts payable days indicate that a company is either taking advantage of early payment discounts or is
simply paying its bills earlier than it has to
...
An alternative approach is to use the
average accounts payable for the reporting period, since the ending figure may be
disproportionately high or low
...
Also, depreciation
and amortization should be excluded from the purchases figure since they do not
involve cash payments
...
On an annualized basis, its
total expenses are $2,400,000, of which $600,000 is payroll and $50,000 is depreciation
...
If a company has an irregular flow of business over the

84 / Business Ratios and Formulas

course of a year, then estimating the amount of purchases can be quite difficult
...

The measurement can yield inaccurate results if a company is making large additional purchases that are being capitalized into inventory or fixed assets
...

This situation can be reversed if a company is drawing down its inventory stockpiles to make sales rather than purchasing new inventory to meet the sales requirements, which will yield greater liquidity than is indicated by the measurement
...
This variation does not yield the number
of days of outstanding accounts payable but rather the number of times per year
that purchases are being paid off
...
Accounts payable turnover is most understandable when tracked on a trend line, an increasing turnover trend indicates
more rapid payment of accounts payable, while a declining trend indicates the reverse
...


An alternative approach is to use the average accounts payable for the reporting
period, since the ending figure may be disproportionately high or low
...
Also, depreciation and amortization should be excluded from
the purchases figure since they do not involve cash payments
...
It has ending accounts payable of
$157,000 and annualized purchases of $1,750,000
...
1 Accounts payable turnover
Cautions: The same cautions noted for the accounts payable days measurement

apply to the accounts payable turnover calculation as well
...
A current ratio of 1:1 is considered to be the absolute minimum level of acceptable liquidity, whereas a ratio
closer to 2:1 is preferred
...
The formula is:

Current assets
———————
Current liabilities
Example: A prospective purchaser is interested in the current financial health of

the Ginseng Plus retail chain, which sells herbal remedies for common maladies
...
6 about the company for the past
three years
...
The sudden
jump in current liabilities in the last year is particularly disturbing and is indicative of the company suddenly being unable to pay its accounts payable, which
have correspondingly ballooned
...

Cautions: This measurement can be misleading if a company’s current assets are

heavily weighted in favor of inventories, since this current asset can be difficult to
liquidate in the short term
...

Table 5
...
7:1

$11,700,000
$9,000,000
1
...
In these instances, a company
will add all possible costs to its cost allocation pools and then use allocation methods that tend to charge the highest possible amounts of these costs to inventory
...

Another problem is that the current ratio will look abnormally low for those
companies that are drawing down cash from a line of credit, since they tend to
keep cash balances at a minimum and only replenish their cash when it is absolutely required to pay for liabilities
...


QUICK RATIO
Description: Because of the presence of inventory in the current ratio that was

covered in the last section, the current ratio may not be the best measure of a company’s liquidity
...
By doing so, one can gain
a better understanding of a company’s very short-term ability to generate cash
from more liquid assets, such as accounts receivable and marketable securities
...
Be sure to include only those marketable securities that can be liquidated in the short term and those receivables that
are not significantly overdue
...
5:1
...
7
...

Only by switching to the quick ratio is this problem revealed
...
If this may be a problem, use the cash ratio,
which is described in the next section
...
7
Account

Amount

Cash
Marketable securities
Accounts receivable
Inventory
Current liabilities
Current ratio
Quick ratio

$120,000
$53,000
$418,000
$2,364,000
$985,000
3:1
0
...
This ratio uses
only cash and short-term marketable securities in the numerator, and so it is the
best way to see what proportion of liabilities absolutely, positively can be paid
right away
...

Formula: Add together all cash and short-term marketable securities, and divide

the sum by the total of all current liabilities
...
The CFO is concerned that some liabilities may not have been
paid on time and orders an immediate calculation of the cash ratio to see if the
company has the wherewithal to meet its obligations
...
Current liabilities are $415,000
...
The CFO takes immediate steps to create a factoring arrangement with
the local bank, in case the company needs to sell off any accounts receivable to
meet its obligations
...
Though rare, one should explore this possibility to ensure that the results of the cash ratio are valid
...
If a company is forced to use such financing techniques as accounts receivable factoring to pay for its ongoing operations, then the
amount of its current assets will be very low
...
The size of the ratio will vary considerably by industry, so a better sign of problems is a steady increase in the ratio over time, no matter what the
exact ratio measurement may be
...
The ratio is:

Sales
——————
Current assets
Example: An auditor is preparing the annual report for the Snowflake Sled Com-

pany
...
To research this issue, the auditor compiles Table 5
...


Table 5
...
This means that the company may fail suddenly
...

Cautions: This ratio is not valid in situations where a company is selling goods

on a drop-ship arrangement with its supplier, since this means that the company
records sales even though it never has possession of the goods, which are shipped
directly from the supplier to the customer
...

The ratio’s results can also be suspect in cases where a company accepts a large
part of its sales with credit card payments, since this will drop accounts receivable
balances to near zero, depending upon whether cash receipts are recognized at the
time when a credit card sale is recorded or when cash is received from the bank
supporting the customer’s credit card
...


WORKING CAPITAL PRODUCTIVITY
Description: The working capital productivity measure is similar to the sales to

current assets ratio, in that both are used to see if there are enough assets available
to support a given level of sales activity
...

Alternatively, an excessively low working capital productivity measurement
reveals that a company is inefficient at producing sales because it has too much invested in accounts receivable and/or inventory to produce a given level of sales
...

Formula: Divide annual sales by total working capital
...
The formula is:
Annual sales
———————
Working capital
Example: The Twosome Toboggan Company, makers of extra-large toboggans

for wide loads, has reported a reasonable sales to current assets ratio of 4:1, which
is comparable to the rest of the industry
...
Accordingly, the
lender obtains the company’s most recent balance sheet, which contains the following information:
Annual sales
Cash
Accounts receivable
Inventory
Accounts payable

$6,500,000
$150,000
$400,000
$1,075,000
$695,000

With this information, the lender derives the working capital productivity measurement as follows:
Annual sales
——————— =
Working capital
$6,500,000 Annual sales
——————————————————————————— =
$150,000 Cash + $400,000 Receivables + $1,075,000 Inventory –
$695,000 Payables =
$6,500,000 Annual sales
——————————— =
$930,000 Working capital
7:1 Working capital productivity
An inordinate amount of accounts payable reduces the amount of working capital available to support sales, resulting in far fewer net assets than was initially indicated by the sales to current assets ratio
...

Cautions: This is generally a reliable measure, but its main failing is in the de-

rivation of the annual sales figure in the numerator
...
There can also be a problem if the measurement is made at the end of
a high seasonal sales peak, since annualized sales will appear to be quite high, but
the inventory component associated with working capital will have been greatly
reduced, resulting in a ratio that appears to be too high
...
There is no set minimum number of days that is

Liquidity Measurements / 91

considered acceptable; instead, this measure should be tracked on a trend line to
see if a company’s ability to pay its bills is gradually being reduced over time
...


Then determine the amount of expected daily operating expenses by compiling
known upcoming expenses and creating a daily average expense
...
When deriving the amount of liquid assets, do not include any marketable securities that cannot be liquidated in the
short term nor any of the accounts receivable for which collection is in doubt
...
It is expecting a large payment in 40 days that will relieve
its cash difficulties
...
The company requires
roughly $13,000 on a daily basis to cover its expenses and that it has cash of
$42,000, marketable securities of $119,000, and accounts receivable of $255,000
...
The
CFO begins calling lenders to obtain a short-term loan to cover the projected
shortfall
...
For example, a large rent or payroll payment may be due on
a specific date, although it is incorporated into the expected daily operating expense figure as a much smaller daily payment that is spread over the entire rent period
...
To avoid this problem, one
should supplement the measure with a detailed review of the exact timing of payments for upcoming accounts payable
...
However, any business with ongoing sales will have a constant inflow of new accounts receivable, as customers are provided with goods and
services
...


CURRENT LIABILITY RATIO
Description: The current liability ratio is used to determine the proportion of
total liabilities that are due for payment in the near term
...
Consequently, it is
most useful when tracked on a trend line, to see if a company’s proportion of current liabilities to total liabilities is worsening or improving over time
...
An alternative approach is

to list in the numerator only those liabilities that are due for payment within a
shorter time frame, such as the next month or quarter
...
The basic
formula is:
Current liabilities
————————
Total liabilities
Example: The Powder Hound Snowmobile Company’s new CFO thinks that it

may be time to restructure the company’s debt so that more of it can be shifted out
into the future
...
9
...
Consequently, the CFO elects to conduct negotiations with lenders, with the objective
of converting many of these short-term liabilities into long-term ones
...
9

Current liabilities
Total liabilities
Current liability ratio

2000

2001

2002

$329,000
$940,000
35%

$384,000
$800,000
48%

$407,000
$690,000
59%

Liquidity Measurements / 93
Cautions: As noted in the description, this ratio yields an approximate view of a

company’s liquidity, since it does not show the ability of the company to pay any
amount of liabilities
...
Therefore, the one-year cutoff is an arbitrary factor that can skew the results
of the measurement
...
Similarly, there may be no need
for any long-term debt
...


REQUIRED CURRENT LIABILITIES TO TOTAL CURRENT
LIABILITIES RATIO
Description: A comparison of required current liabilities to total current liabilities
is a good measure for determining a company’s extremely short-term liability
problems
...

Formula: Divide the total amount of all current liabilities with required payment

dates by the total of all current liabilities
...
Some
experimentation with the ratio’s results is needed to determine the exact time period used and the relevance of the resulting information
...
It needs to

get through the next month to enter its prime spring selling season and bring in
some cash
...

Within the one-month time frame, the company must pay $148,000, while its total
current liabilities are $197,000
...
A better approach is to measure it on a trend line, or to compare it to the same period in
the preceding year, when the liability proportion should have been about the same
...


WORKING CAPITAL TO DEBT RATIO
Description: The working capital to debt ratio is used to see if a company could

pay off its debt by liquidating its working capital
...

Formula: Add up cash, accounts receivable, and inventory, and subtract all ac-

counts payable from the sum
...
A variation is
to use only short-term debt in the denominator, on the grounds that only this portion of the debt will come due for payment
...
Because of the covenant violations, the bank has elected to call in
its loan immediately
...
However, a closer examination of the components of working
capital reveals that current cash and receivable levels would only pay off accounts
payable, leaving the loan to be paid from the much less liquid inventory balance
...
The bank vice president elects to work with company management to
achieve a payback over a longer time period
...
If the proportion of inventory to working capital is high, then a company’s
apparent ability to pay off a debt in the short term will be exaggerated by this ratio
...
This is of considerable interest to an acquirer or lender, since these
entities need to understand the underlying value of the corporation in which they
are investing debt or equity
...

If a company has a high ratio, then it not only has little liquidation value, but also
may be in danger of going out of business if it must suddenly pay off a large
amount of liabilities with its small proportion of concrete assets
...
The numerator should
include all intangibles as well as all highly customized equipment (since these
may be especially difficult to sell)
...
10
Asset Type

Book Value

Gross intangible assets
Gross customized equipment
Amortization of intangible assets
Depreciation on customized equipment
Total assets

$225,000
$450,000
$60,000
$120,000
$3,050,000

Example: A potential acquirer is reviewing the financial information of the Pe-

terson Motor Company (PMC), with the intention of selling off its assets
...
10
...
2% Risky asset conversion ratio
The acquirer’s preliminary review shows a relatively low proportion of risky
assets, so it proceeds with its due diligence by hiring an outside appraisal firm to
conduct a more detailed review of the PMC assets
...
For an accurate measurement, an appraiser should regularly review a company’s entire list of assets
...
A ratio equal to or
greater than one is indicative of having a reasonable ability to do so
...


Liquidity Measurements / 97
Formula: Divide the net book value of all noncurrent assets by all noncurrent li-

abilities
...
The formula is:
Non-current assets
—————————
Non-current liabilities
Example: The lender for the Primo Sport Fishing Company is considering calling

its loan to the company and is concerned that the company cannot pay off the loan
in the short term
...
Information from the company’s balance sheet is shown in Table 5
...

The lending officer elects to exclude the goodwill asset from the noncurrent assets to noncurrent liabilities ratio, since this item may not have any resale value
...

Cautions: The primary problem with this ratio is its assumption that all of the

funds needed to pay down debt are located in the noncurrent assets portion of the
balance sheet
...
In order to include this extra
source of funds, the current assets should be netted against all current liabilities,
and then any excess current liabilities included in the numerator of the ratio
...
11
Account
Fixed assets
Depreciation
Goodwill
Long-term debt

Amount
$815,000
$350,000
$725,000
$1,500,000

98 / Business Ratios and Formulas

Another problem with this ratio is that it assumes a lender will require a complete pay-down of its long-term debt with immediately available assets, which
most companies will not have
...

A third issue is that the valuation of the noncurrent assets listed in the denominator may bear little comparison to their actual resale values; for example,
a company could liquidate its fixed assets and obtain far less cash from the transaction than the listed book value would indicate
...


SHORT-TERM DEBT TO LONG-TERM DEBT RATIO
Description: The ratio of short-term debt to long-term debt reveals the proportion
of total debt that is coming due for payment in the near term
...

Formula: Divide total short-term debt by total long-term debt
...
The formula is:
Total short-term debt
—————————
Total long-term debt
Example: The Guttering Candle Company, maker of beeswax candles, has ap-

plied to the First National Industrial Bank for a loan
...
12
...
This can indicate that other
lenders have turned down the company’s loan application in the past
...
12

Short-term debt
Long-term debt
Short-term debt to long-term debt ratio

2000

2001

2002

$480,000
$965,000
50%

$620,000
$925,000
67%

$804,000
$880,000
91%

Liquidity Measurements / 99

ficer decides to review the company’s ability to pay off loans with great care before issuing any funds
...

It can also be misleading if a debt balloon payment has recently shifted from the
long-term debt category to the short-term category, although a company must be
making arrangements to roll forward the balloon payment if it does not expect to
pay it off in the short term
...
If this ratio shows a large proportion
of short-term debt coming due, but there is a large amount of available borrowing
base, then it is reasonable to assume that the company can obtain additional financing, up to the amount of the available borrowing base, to shift debt to the
long-term category
...
Edward
Altman to determine the likelihood of a company going bankrupt at some point in
the future
...
The calculation can also be used by a lender to determine the creditworthiness of a company
...
99, a company is probably in safe
financial condition
...
0 and 2
...
A score between 2
...
8 indicates that
a company will probably be bankrupt within two years
...
8 indicates a high risk of bankruptcy in the near future
...

2
...

4
...


Return on total assets × 3
...
999 weighting factor
Equity to debt × 0
...
2 weighting factor
Retained earnings to total assets × 1
...
3
+
(Sales / Total assets) × 0
...
6
+
(Working capital / Total assets) × 1
...
4
This derivation of the Z-score uses weighting factors that are applicable to
publicly held companies
...
1 weighting factor
Sales to total assets × 0
...
42 weighting factor
Working capital to total assets × 0
...
84 weighting factor
Example: Calculate the Z-score for the Children’s Furniture Factory, using the in-

formation in Table 5
...

The calculation is:
($25,000 Operating income / $960,000 Total assets) × 3
...
09
+
($1,000,000 Sales / $960,000 Total assets) × 0
...
04
+
($485,000 Market value of stock) / ($705,000 Total liabilities) × 0
...
41
+
($175,000 Working capital / $960,000 Total assets) × 1
...
22
+
($180,000 Retained earnings / $960,000 Total assets) × 1
...
19
Table 5
...
14
Ratio
Weighted return on total assets ratio
Weighted sales to total assets ratio
Weighted equity to debt ratio
Weighted working capital to total assets ratio
Weighted retained earnings to total assets ratio
Total Z-score

Z-Score
0
...
04
0
...
22
0
...
95

When these calculations are summarized, we arrive at the Z-score shown in
Table 5
...

With a low score of only 1
...

Cautions: The results of this calculation are reliable only if there is no fraudulent

financial reporting by a company that results in a higher Z-score than would otherwise be the case
...


6
Capital Structure and
Solvency Measurements

T

his chapter contains several measurements that can be used to determine the relationship between a company’s debt and equity as well as the comparative
proportions of different types of stock
...
Solvency is a key concern in Chapter 4, which describes cash flow
measurements
...

The measurements discussed in this chapter are:
Times Interest Earned
Debt Coverage Ratio
Asset Quality Index
Accruals to Assets Ratio
Times Preferred Dividend Earned
Debt to Equity Ratio
Funded Capital Ratio

Retained Earnings to Stockholders’ Equity
Preferred Stock to Total Stockholders’ Equity
Issued Shares to Authorized
Shares

TIMES INTEREST EARNED
Description: An investor or lender should be interested in a company’s ability to

pay its debts
...
If this
ratio is close to one, then the company runs a high risk of defaulting on its debt,
whereas any higher ratio shows that it is operating with a comfortable amount of
extra cash flow that can cushion it if its business falters
...
Cash flow

is a company’s net income, to which all noncash expenses (such as depreciation
103

104 / Business Ratios and Formulas

Table 6
...
3

$43,000
$65,000
$17,250
$2,500
$84,750
2
...
6

and amortization) have been added back
...
The formula is:
Average cash flow
———————————
Average interest expense
Example: The Cautious Bankers Corporation (CBC) is investigating the possi-

bility of lending money to the Grasp & Sons Door Handle Corporation (GSR)
...
1 shows the information CBC has collected for the last few months on
GSR’s operations
...
The CBC examiner elects to pass on providing the company with any additional debt
...
Though many companies simply roll over expiring debt into new debt instruments, it is not always possible for
those in difficult financial situations
...


This can be measured with the debt coverage ratio, which compares reported earnings to the amount of scheduled after-tax interest and principal payments to see if
there is enough income available to cover the payments
...
The measure is of particular interest to lenders, who are concerned about a
company’s ability to repay them for issued loans
...
This yields the amount of after-tax income required by a
company to pay back the principal
...
An alternative treatment of the numerator is to use earnings before interest, taxes, depreciation, and amortization, because this yields a closer approximation of available
cash flow
...
The expected operating income for the year, prior to bonuses, is $135,000
...
The tax rate is 34%
...

The controller uses the following debt coverage calculation to see if Christmas
bonuses can still be paid:

Earnings before interest and taxes
————————–————————— =
Scheduled principal payments
Interest + —————————————
(1 – Tax rate)
$135,000 Operating income
———————————–————————— =
$59,000 Principal payments
$18,500 Interest + ————————————
(1 – 34% Tax rate)
$135,000 Operating income
———————————— =
$107,894 Debt payments
125% Debt coverage ratio
The ratio indicates that extra funds will be available for Christmas bonuses
since operating income exceeds the amount of scheduled debt payments
...
It is usually derived from information contained within
the financial statements, which report earnings on an historical basis, but gives no
view of expected earnings levels, which may be considerably different
...


106 / Business Ratios and Formulas

ASSET QUALITY INDEX
Description: The asset quality index is an excellent measurement for locating

companies that are capitalizing an increasing proportion of their costs over time,
which can be a sign of changes in accounting methods that are designed to show
an increased level of profitability than is really the case
...
A measurement result of one is normal, while anything substantially
below that figure is indicative of either financial distress or a push to increase the
level of reported earnings above their rightful level
...
Then
run the same calculation for period one, and divide the result for period one into
the result for period two
...
An
investment analyst chooses to use the asset quality index to see if there is evidence
that the company is shifting expenses into its fixed assets in order to bolster its reported earnings
...
2:
Table 6
...
82
———— =
1 – 0
...
18
—— 64% Asset quality index
0
...
For example, a manager may choose to swap out a
copier that was used under an operating lease for one that the company owns
under a capital lease; the nature of the asset has not changed, but the owner has,
so the amount of fixed assets on the company’s books will increase
...
For
example, the company controller may request an increase in the capitalization
limit, from $1,000 to $2,000, so that the accounting staff will not have so great an
asset-tracking burden
...

The measurement can also be altered by changes in the depreciation calculation
for fixed assets because the measurement records fixed assets net of depreciation
...


ACCRUALS TO ASSETS RATIO
Description: A key solvency issue for an outside investigator, such as an investor, lender, or investment analyst, is the presence of any changes in accruals
over time that might be evidence of accounting tampering in order to modify a
company’s reported financial results
...
If the proportion of accruals to assets
is increasing, accounting tampering may be covering a solvency issue or at least
pumping up reported earnings beyond their actual level
...
Then subtract from this amount the net change in cash and depreciation over the same time period
...
There should be no excessive usage of accruals if the ratio results in
the same figure over several periods, whereas it may indicate more aggressive accounting practices if the ratio increases over time
...
The analyst suspects that the company is hiding weak financial results
within this obfuscation
...
3
...
The analyst investigates fur-

Table 6
...
Yet another level of detailed research leads to the conclusion that the company has altered its inventory costing system in order to capitalize more overhead costs into inventory, thereby increasing the reported level of
earnings
...

Cautions: This measurement calculates the level of accruals that a company is

using by assuming that the proportions of the various balance sheet line items to
total assets will remain the same from year to year, and that only accruals will be
the cause of any differences
...
For example, if the management team has elected to ease credit restrictions
on new customers in order to increase sales, then the proportion of accounts receivable to total assets will very likely increase because of the addition of lowercredit customers
...
Consequently, these
types of changes can make the accruals to assets ratio look substantially better or
worse than it really is
...


TIMES PREFERRED DIVIDEND EARNED
Description: The owner of a company’s preferred shares will have a considerable

degree of interest in the company’s ability to spin off enough cash flow to pay for
any preferred dividends
...
This is of particular interest to both parties when the amount of the preferred
dividend is locked in by the preferred stock agreement rather than being a variable
amount that is approved by the board of directors
...
The resulting number yields a high degree of confidence in a
company’s ability to pay the dividend if it is substantially greater than one
...
Another variation is to use net cash flow in the numerator, rather
than the reported amount of net income, since this strips away any noncash expense or revenue factors that may be included in the net income figure
...
Under their shareholder agreement,
they have the authority to force the sale of the company if preferred stock dividends are not paid in a timely manner
...
In the
current year, the company has earned $210,000
...
To see if the payment can be made, they calculate the times preferred dividend earned measurement, as:
Net income
———————— =
Preferred dividend
$210,000 Net income
—————————————————————————————— =
48,000 Preferred shares × $18 Price per share × 8% Dividend × 3 Years
$210,000 Net income
———————————— =
$207,360 Preferred dividend
1
...

Cautions: The preferred stock dividend can be avoided under many preferred

stock agreements; however, if it is not paid, it becomes cumulative and must be
paid at some specific future date or, more commonly, prior to the distribution of
dividends to common shareholders
...

Also, the formula does not account for a company’s prospective cash flow
needs in the near term, such as capital expenditures, that may keep it from paying
the dividend
...
For example, a company that
wants to increase its return on equity can do so by obtaining debt, which it then

Capital Structure and Solvency Measurements / 111

uses to buy back stock, thereby shrinking the amount of equity that is used to calculate the return on equity
...

Lenders are particularly concerned about this ratio, since an excessively high
ratio of debt to equity will put their loans at risk of not being repaid
...

Formula: Divide total debt by total equity
...
The formula is:
Debt
———
Equity
A more restrictive view of the formula is to include only long-tem debt in the
numerator, on the assumption that this variation gives a better picture of a company’s long-term debt to equity structure
...

Example: The Conemaugh Cell Phone Company has piled up a great deal of debt
while purchasing new bandwidth from the federal government in the key St
...
Its existing debt covenants already stipulate that the company cannot
exceed a debt to equity ratio of 11⁄2 to 1
...
Given its existing equity
level of $182,000,000 and outstanding debt of $243,000,000, will it exceed the
covenanted debt to equity ratio? To answer this question, the following formula is
used:

Debt
——— =
Equity
$243,000,000 Outstanding debt + $55,000,000 Required debt
————————————————————————— =
$182,000,000 Existing equity =
$298,000,000 Total debt
———————————— =
$182,000,000 Total equity
164% Debt to equity ratio

112 / Business Ratios and Formulas

The debt to equity ratio resulting from the proposed deal will exceed the
covenant, so Conemaugh must either renegotiate the covenant or complete the acquisition with a mix of debt and equity that will not violate the covenant
...
The reason for this approach is
that a large amount of total debt on the balance sheet may not reveal a true picture
of a company’s ability to pay it off if the debt is not due for payment until a required balloon payment at some point well into the future
...


FUNDED CAPITAL RATIO
Description: This ratio shows the proportion of fixed assets that are being funded

by long-term funding, which is defined as long-term debt and stockholders’ equity
...
At some point in the future, this could
give rise to a dangerous situation where the company can only refinance its shortterm debt at very high interest rates or is unable to refinance at all, possibly resulting in either corporate liquidation or the sale of assets
...
If gen-

erally accepted accounting principles (GAAP) are properly applied to the recording of capital leases, the debt associated with these leases that is not due for
payment within one year will already be recorded as long-term debt
...
The formula is:
Stockholders’ equity + Long-term debt
————————————————
Fixed assets
Example: The Manila Rope Company has operated on a shoestring for a number

of years, having financed its rope-making equipment with short-term loans from
relatives and credit card providers
...
The company’s stockholders’ equity is $128,000, its long-term debt is $30,000, and it has $311,000 in net
fixed assets
...
The CFO promptly arranges 10-year capital
leases for the existing rope-making equipment
...
To avoid this problem, use a periodic appraisal of the market value of the fixed assets, and use this amount in the denominator
...


RETAINED EARNINGS TO STOCKHOLDERS’ EQUITY
Description: This ratio is used by lenders and investment analysts to see if a
company is retaining earnings in the business or if they have a penchant for distributing it to the owners
...
This ratio is particularly
applicable in situations where company ownership is closely held, since the small
number of owners can vote themselves dividends out of retained earnings
...
If the account-

ing staff has shifted retained earnings into a reserve for dividends payable, then
this reserve should not be included in the formula, since the intent is to distribute
it
...

These owners regularly distribute the bulk of all earnings to themselves
...
The investigating
lender accumulates the information in Table 6
...


114 / Business Ratios and Formulas

Table 6
...
6%, which is derived as:
$35,000 Retained earnings
———————————————
$225,000 Total stockholders’ equity
The ratio shows that the family is extracting a great deal of money from the
business every year
...
Further questions that the
lending officer needs to resolve are whether the company has a multiyear history
of creating these large profits, and whether the family members will accept a
lower distribution from earnings for a few years to pay off the loan in case the acquisition does not generate more cash flow
...
However, it is also possible that the Internal Revenue Service has required a retained earnings dividend to investors on the grounds that the company
is retaining more earnings than it needs to run the business
...


PREFERRED STOCK TO TOTAL STOCKHOLDERS’ EQUITY
Description: A common stockholder does not want to see a high proportion of

preferred stock to stockholders’ equity, because preferred shares are frequently issued with a number of payment and liquidation preferences that can result in very
little equity being left over for the common shareholders
...
Consequently, a high ratio of preferred stock to
stockholders’ equity can scare away likely common stock investors
...
The formula

is:

Capital Structure and Solvency Measurements / 115

Preferred stock
—————————
Stockholders’ equity
Example: The DbIndex Consulting firm is a Washington, DC-based company

that specializes in security consulting for large government database projects
...
The total amount of stockholders’ equity prior
to the transaction is $1,350,000
...
7% Preferred stock to stockholders’ equity ratio
Though the ratio reveals that the preferred shareholder owns a minority position in the company, the president of DbIndex Consulting does not realize until
later, when the president tries to sell the company, that the investor, according to
the preferred stock agreement, must vote in favor of any such decision
...
In short, the measurement alone did not tell the whole story of how the preferred stock sale impacted
the other shareholders in the business
...
A potential common stock investor should obtain the preferred stock
agreement and peruse it to see what special privileges have been guaranteed to the
preferred shareholders in order to have an accurate idea of the payment and liquidation preferences that have been signed over to them
...


ISSUED SHARES TO AUTHORIZED SHARES
Description: The ratio of issued to authorized shares tells the CFO if it is necessary

to go to the board of directors to ask for an additional authorization of shares
...


116 / Business Ratios and Formulas
Formula: Divide the total number of issued shares by the total number of autho-

rized shares
...
This gives a better feel for the
number of shares that will be available if all of these stock rights are converted
into shares
...
The formula is:
Issued shares + Stock options + Stock warrants + Convertible securities
——————————————————————————————
Total authorized shares
Example: The CFO of the Prudent Insurance Company is conservative and wants

to be certain that there are enough authorized shares available to meet all possible
financing needs
...
5
...
By using the expanded form of the
issued shares to authorized shares ratio, the CFO arrives at this result prior to the
planned sale of additional equity:
Issued shares + Stock options + Stock warrants + Convertible securities =
—————————————————————————————— =
Total authorized shares =
23,524,000 Issued shares + 1,805,000 Stock options +
125,000 Stock warrants + 2,480,000 Shares from convertible securities
—————————————————————————————— =
28,000,000 Total authorized shares =

Table 6
...
8% =
The ratio shows that there is just barely enough authorized shares on hand to
cover all possible demands on the number of authorized shares
...
The new equity offering would require
3,500,000 additional shares ($98,000,000 of total equity divided by $28 share),
which would increase the ratio to 112%
...

Cautions: Good judgment is required when using the expanded form of this mea-

surement, because some or all of the existing options, warrants, and convertible
securities may never by converted into shares, depending on whether options are
vested or if any of the various categories of near-stock are in the money, so investors will have an incentive to purchase the stock
...
The determination of when
near-stock will be “in the money” at some future date is much more difficult to
predict, so it is generally best to calculate the ratio based on low-medium-high predictions of conversions to stock to see if there are any scenarios where the number of shares authorized would not be sufficient
...


7
Return on Investment
Measurements

T

his chapter is aimed squarely at measurements that can be used to determine a
company’s ability to create a return on investment
...
They can be used by investors to determine
what to pay for a company’s shares as well as to measure the return on investment
...
The measures discussed in this chapter are:
Net Worth
Book Value per Share
Tangible Book Value
Return on Assets Employed
Return on Operating Assets
Return on Equity Percentage
Return on Common Equity
Financial Leverage Index

Equity Growth Rate
Earnings per Share
Percentage Change in Earnings per
Share
Economic Value Added
Dividend Payout Ratio
Dividend Yield Ratio

NET WORTH
Description: A company’s net worth is the amount of money that is left over after

all its liabilities have been deducted from its assets
...
A negative net worth is a reasonable indicator of serious fiscal problems
...


119

120 / Business Ratios and Formulas
Formula: In its simplest form, the net worth calculation is found by subtracting

total liabilities from total assets
...
In essence, every obligation of the company to make a payment, whether
it be included on the balance sheet as a liability or not, should be subtracted from
total assets in order to arrive at a company’s net worth
...
If
so, the preceding calculation can be divided by the total amount of outstanding
common shares
...
The formula is:
Total assets – Total liabilities – Preferred stock dividends
————————————————————————
Total outstanding common shares
Example: The Bottomless Bathtub Company, maker of fine porcelain tubs, has

obtained a $2,000,000 loan from the First Federal Bank to cover the cost of a facility expansion
...
The controller is reviewing the balance sheet for February, which is one month prior to its
quarterly report to the bank
...
The controller knows that March is expected to be a breakeven month, so liabilities will not be reduced
...

Cautions: The primary difficulty with the net worth measurement is that it is
based on historical valuations that may have little basis in present market conditions
...
Similarly,
if a company holds title to a valuable patent, only the capitalized legal costs associated with the patent will appear as an asset, even though the value of the patent
itself may be much higher
...
For these reasons, detailed knowledge of a company’s individual assets and liabilities is a better tool for determining net worth than the simple
calculation presented here, which is based on historical accounting information
...

A higher market price indicates that investors have assigned extra value to a company, perhaps due to excellent management, products, patents, and so on
...

Formula: Determine the amount of the payout needed to liquidate all preferred

stock, which may include not only the payback of the original stock purchase price
but also a preferential return and accumulated but unpaid dividends
...
The formula is:
Total equity – Cost to liquidate preferred stock
———————————————————
Total number of common shares outstanding
This measure can also be targeted at specific types of stock
...
Accordingly, the tangible book value measurement can be used to
strip the value of goodwill and other intangibles from a company’s book value
...
The amount of all intangibles used in the calculation should be net of any amortization and valuation
write-downs
...
All of the purchases involved prices well above the
fair market value of the assets bought, resulting in substantial increases in the Book
Rack’s goodwill account
...

The company’s book value is $43,800,000, the total goodwill on its books is
$29,300,000, and the capitalized legal costs associated with its trademarks is
$439,000
...

Cautions: This measure can focus too exclusively on tangible assets, since there
may be extremely valuable intangible assets on the books, such as patents or brands
...
If this approach is used, it would be useful to itemize in a footnote the
specific intangibles that were added back, as well as the cost assigned to them
...
This also keeps
investors from having to put more cash into the company and allows the company
to shift its excess cash to investments in new endeavors
...


124 / Business Ratios and Formulas
Formula: Divide net profits by total assets
...
The amount of fixed assets
included in the denominator is typically net of depreciation; it can also be recorded
at its gross value, as long as the formula derivation is used consistently over multiple time periods, thereby ensuring consistent long-term reporting
...
Willston is the new owner of Southern Sheet Metal, a metal stamp-

ing company
...
He
has the controller collect the information about company income and assets that is
shown in Table 7
...

Based on the table, the calculation of net assets employed is:
Net profit
————— =
Total assets =
$215,000
————— =
$2,923,000 =
7
...
Willston is not certain which of the fixed assets can be
safely eliminated while maintaining productive capacity
...
Accordingly, he improves collection activities and early payment discounts
and drops the outstanding accounts receivable balance from 60 days to 45, reducing this asset to $384,000
...
By taking these actions, he has eliminated $280,000

Table 7
...
He has also improved the net assets employed measurement to 8
...
1%
Cautions: This measurement is of no use in cases where there are minimal prof-

its, since the ratio can fluctuate considerably on a percentage basis with slight
changes in the level of profit
...
Although the value of short-term
assets such as accounts receivable is probably quite accurate, this may not be the
case for facilities and equipment that were obtained many years ago
...


RETURN ON OPERATING ASSETS
Description: This measure varies somewhat from return on assets employed be-

cause only those assets actively used to create revenue are used in the denominator
...
A typical result of this measurement is an ongoing campaign to eliminate unnecessary assets
...
An asset valuation that is net of depreciation can also be used, but the
type of depreciation calculation can skew the net amount significantly, since some
accelerated depreciation methods eliminate as much as 40% of an asset’s value in
its first full year of usage
...
The formula is:
Net income
—————————————
Assets used to create revenue
Example: Quality Cabinets, an old maker of fine mahogany cabinets, has accu-

mulated several pieces of equipment over the years that are only occasionally
used in the production process
...
The company had income of $230,000 in the last year
...
With this information, the CFO calculates the return on
operating assets as:
Net income
————————————— =
Assets used to create revenue
$230,000 Net income
—————————————————————— =
$700,000 Total assets – $85,000 Unproductive assets
37% Return on operating assets
Cautions: The specific assets included in the denominator can be subject to a

great deal of interpretation, since managers realize that any assets not included in
it will eventually become targets for elimination
...


RETURN ON EQUITY PERCENTAGE
Description: This calculation is used by investors to determine the amount of return
they are receiving from their capital investment in a company
...

Formulas: Divide net income by total equity
...
The
basic formula is:

Return on Investment Measurements / 127

Net income
—————
Total equity
Example: The president of the Lounger Chairs Furniture Company has been pro-

vided with a bonus plan that is largely based on the increase achieved on return on
equity for the shareholders
...
The president estimates that it will be possible to buy back $300,000 of
the stock from small investors by obtaining a loan that has an after-tax interest rate
of 8%
...
2 to see if the stratagem
makes sense:
Table 7
...
Though expenses will be driven up by
the interest cost of the debt, the amount of equity will be reduced to such an extent that the return on equity will increase by 3%
...

Cautions: A management team that is eager to increase a company’s return on

equity can easily do so by incurring new debt and using these funds to buy back
stock
...
An overly zealous pursuit of this approach can result in such a large debt
load that a small downturn in sales will not allow it to pay off the debt, possibly
ending in bankruptcy
...


RETURN ON COMMON EQUITY
Description: A variation on the last measurement (return on equity percentage) is

return on common equity
...
Thus a more accurate estimate is obtained of the return to common
shareholders excluding the returns to the holders of all other types of stock
...

Formula: Subtract any preferred stock dividends from net income, and divide the

result by common stockholders’ equity
...
The
original owners of the firm’s common stock would like to see how their return has
been diminished by this transaction, and they calculate the return on common equity to find out
...
50 dividend per share at the end of the fiscal year
...
Common stockholders’ equity was $585,000
...
Using this information, the return on common equity
is calculated as:
Net income – Preferred stock dividends
————————————————— =
Common stockholders’ equity
($128,000 Net income) – ($3
...
9% Return on common equity
If the Series A stock had not been issued, then the preferred dividend could
have been eliminated from the transaction, which would have increased the common shareholders’ return to a much higher 22%
...

Cautions: A common clause in preferred stock agreements is that preferred stock
shareholders will receive dividends in the same amount as any given to common
shareholders
...
Also, there may be a cumulative

Return on Investment Measurements / 129

dividend clause that pays dividends to preferred shareholders if the company did
not make such payments at an earlier date; any of these unpaid amounts should be
included in the numerator portion of the measurement
...
It
compares the rate of return on equity to the rate of return on assets
...

Formula: Divide net income by the total amount of equity, and divide net income

by the total amount of assets
...
The formula is:
Return on equity
———————
Return on assets
Example: The Everlast Shoe Company, maker of steel-toed boots, has generated

the following financial information for its last fiscal year:
Net income
Total equity
Total assets

$140,000
315,000
875,000

Based on this information, the financial leverage index is calculated in the following manner:
Net income/Total equity
—————————— =
Net income/Total assets
$140,000 Net income/$315,000 Total equity
——————————————————— =
$140,000 Net income/$875,000 Total assets
44
...
0% Return on assets
278% Financial leverage index
With such a high financial leverage index, it is apparent that the company is financing a significant proportion of its growth with liabilities
...
This can be easily obtained
by a glance at the financial statements rather than by laboriously compiling this
calculation
...
By doing so,
shareholders can see if their equity pool is increasing or decreasing and by how
much
...

Formula: Subtract all nonexpense payments from net income, which are divi-

dends for both common and preferred shareholders, and divide the result by beginning common stockholders’ equity
...
The
formula is:
Net income – Common stock dividends – Preferred stock dividends
————————————————————————————
Beginning common stockholders’ equity
Example: The Altruistic Gasket Company had net income of $420,000 in the last

year
...
The beginning balance in the common stockholders’ equity account was $1,635,000
...
0% Equity growth rate

Return on Investment Measurements / 131
Cautions: There may be very good reasons for issuances of dividends that pre-

vent the amount of equity from growing
...
In short, there may be good reasons for a moderate or negative equity growth rate
...
It is useful for shareholders to determine changes in
earnings per share held over a period of time
...
The amount of common stock equivalents is the total of
all vested warrants and options as well as all convertible securities that have
not yet been converted into common stock; this figure tends to be too high,
since the holders of these common stock equivalents will frequently not exercise
their rights to purchase common stock
...
The formula is:
Net income – Dividends on preferred stock
——————————————————
Number of outstanding common shares + Common stock equivalents
Example: The controller of the Open Sesame Garage Door Company is calculat-

ing the earnings per share for the company, given the following information:
Net income
Preferred stock dividends
Shares of common stock
Number of vested options
Number of convertible bonds
Number of warrants

$250,000
$28,000
4,500,000
125,000
20,000
50,000

If the controller calculates earnings per share on a nondiluted basis, the formula
will not include the options, convertible securities, or warrants shown
...
049/share
If the options, convertible securities, and warrants are added to the calculation
on a fully diluted basis, then the calculation is:
$250,000 – $28,000
————————————————— =
4,500,000 + 125,000 + 20,000 + 50,000
$222,000
———— =
4,695,000
$
...
Although it is indicative

of a company’s overall operating condition, it can be skewed by nonoperating
charges or credits, and it will also not reveal a company’s cash position
...
Also, as noted in the Formula section, the amount of common stock equivalents is frequently overstated,
which tends to artificially reduce the amount of earnings per share
...
A company producing a lengthy string of gradual increases in
EPS over many quarters is considered to be evidence of good management
...
It is possible that EPS will be modified
by the management team in order to report a string of continuing increases (see the
Cautions section); an alternative form of reporting is to base this measurement on
cash flow per share, which is more difficult to alter
...
Its EPS in the preceding period were $1
...
During the current period, it increased its common stock outstanding from 1,725,000 to
1,850,000, whereas the earnings reported were $2,300,000
...
29
...
29 Latest earnings per share – $1
...
14 Preceding earnings per share
$0
...
14 Preceding earnings per share
13
...
To do
this, managers may engage in a high degree of earnings management that shifts
revenues and expenses into and out of different periods or asset-holding accounts,
thereby modifying earnings to such an extent that it is not possible to tell if the reported level of earnings is the real level of earnings
...
For these
reasons, several other performance measures should be reviewed to see if changes
in the revenue level and expense structure appear to add up to the reported earnings per share, or if there is so much variation in these proportions between reporting periods that there is a good chance of management interference in the
reported numbers
...
Stated differently, this is the surplus

134 / Business Ratios and Formulas

value created on an initial investment
...
If the measurement is negative, then a company is not generating a return in excess of its capital costs
...

EVA has become the most fashionable measurement for determining the ability of a company to generate an appropriate rate of return, thanks in part to the efforts of several consulting firms that specialize in installing the systems that roll
up into this measurement
...
It can also be linked to a company’s compensation system, meaning that
managers are paid based on their ability to combine efficient asset utilization with
profitable operating results
...
The three elements of the calculation are:
1
...
The net investment figure used in the formula is subject to a
great deal of variation
...
However, some assets may be subject to accelerated depreciation calculations, which reduce the amount of investment used in the calculation; a better approach is to use the straight-line depreciation method for all
assets, with only the depreciation period varying by type of asset
...
Also, if assets are
leased rather than owned, they should be itemized as assets at their fair market
value and included in the net investment figure so that managers cannot use financing tricks to enhance their return on investment
...
Actual return on investment
...
In addition, any unusual adjustments to net income that do not involve ongoing operations should
be eliminated
...

3
...
The formulation of the cost of capital is complex; please refer
to the discussion of the cost of capital in Chapter 8
...
3
Type of Funding

Amount of Funding

Cost of Funding

$2,500,000
$4,250,000
$8,000,000
$14,750,000

8
...
5%
16
...
7%

Debt
Preferred stock
Common stock
Total

Example: The CFO of the Miraflores Manufacturing Company wants to see if the

company has a positive economic value added
...
3, the CFO
estimates that the firm’s cost of capital is 13
...

The CFO then takes the balance sheet and income statement and redistributes
some of the accounts in them, in accordance with Table 7
...

The return on investment, as based on the net income and investment figures in
Table 7
...
5% (net income divided by the total net investment)
...
5% Actual return – 13
...
2% =
– $6,230 Economic value added
In short, the company is destroying its capital base by creating actual returns
that are slightly less than its cost of capital
...
4
Account Description
Revenue
Cost of goods sold
General and administrative
Sales department
Training department
Research and development
Marketing department
Net income
Fixed assets
Cost of patent protection
Cost of trademark protection
Total net investment

Performance

Net Investment

$8,250,000
$5,950,000
$825,000
$675,000
$100,000
$585,000
$380,000
$420,000
$2,080,000
$125,000
$225,000
$3,115,000

136 / Business Ratios and Formulas
Cautions: The focus of this measure is to increase the return on capital employed
...
Also, if the calculation is
being made for individual divisions of the same company, the person creating the
measurement may become entangled in complex expense allocations from various
corporate service centers to operating divisions, with constant bickering among
the division managers to reduce their share of these costs
...
This is particularly important
when the ratio is greater than one, since it indicates that a company is dipping into
its cash reserves in order to pay dividends, which is not a sustainable trend
...
If the stock price is stagnant or declining, then investors have a valid concern regarding the proper use of corporate earnings
...
The cash flow

from nonoperating items may be included in the earnings per share figure, since
they will impact the amount of cash available for distribution as dividends
...

Also, it may be necessary to add expected capital expenditures to the earnings per
share figure, if this figure is expected to require a significant proportion of the cash
provided by earnings
...
Jones has invested a large part of his savings in the stock of Illinois
Gas Distribution Company, operator of a nationwide gas pipeline
...
00 per
share, based on its most recent earnings report
...
Jones adjusts the $15,430,000 by adding back $7,000,000 in goodwill
amortization, depreciation of $3,500,000, and a restructuring reserve of
$4,500,000, since none of them involve cash flows (though the restructuring reserve may require a cash outflow at some point in the future)
...
The net income after all of these adjustments
is $26,680,000
...
00 Dividend per share
————————————————————— =
$26,680,000 Adjusted net income/5,450,000 Shares
82% Dividend payout ratio
The ratio reveals that the company is capable of paying out dividends from its
earnings per share
...

Cautions: Earnings per share can be skewed by accounting accruals that do not

reflect actual cash flows
...
To avoid this problem, substitute the earnings per
share in the denominator with cash flow per share
...


DIVIDEND YIELD RATIO
Description: The dividend yield ratio is useful for determining the return earned

by investors from dividends, based on the current market price of a company’s
stock
...

Formula: Divide the dividend per share by the market price per share
...
Also, in cases where the market price of a
stock fluctuates significantly, the average market price during the measurement
period may be used rather than its ending price
...
38 and the second for $1
...
Its stock price for the period averaged $32
...
Based on this information, its dividend yield ratio is:
Dividend per share
—————————— =
Market price per share
($1
...
50) Dividends per share
———————————————— =
$32
...
9% Dividend yield ratio
Cautions: As noted in the Description section, a stock’s value is based on a com-

bination of dividend payments and changes in its stock price, only the first half of
which is covered by this calculation
...


8
Market Performance
Measurements

T

his chapter covers those measurements that are of most use to outsiders who
are reviewing a company’s market performance
...
It also addresses several capital-based measures, such as market value added and the cost of
capital, that are driven by the equity and debt markets’ perception of a company’s
valuation
...
For some stock traders, this is a key part of their stock-pricing
models
...
If the resulting
percentage is less than one, then the presumption is that insiders feel the company’s value will increase
...
The formula is:
139

140 / Business Ratios and Formulas

Number of stock sale transactions by insiders
—————————————————————
Number of stock purchase transactions by insiders
Since the number of stock transactions used in this formula can be skewed by
a large number of small transactions, the calculation can be modified so that it is
based on the total number of shares sold and purchased
...

Example: An investment analyst watches the results of the Hardaway Hair Dryer

Company on a regular basis
...
The relevant information is shown in Table 8
...

By summarizing the information in the table and calculating the insider stock
buy-sell ratio, the analyst arrives at the following measurement:
Number of stock sale transactions by insiders
————————————————————— =
Number of stock purchase transactions by insiders
3 Sale transactions/4 Purchase transactions =
75% Insider stock buy-sell ratio
At first glance, it appears that there is a trend toward the purchase of shares by
company insiders
...
One of the purchases was made by the company’s employee stock ownership plan (ESOP), which probably purchases shares on an ongoing basis irrespective of the stock price
...
Counterbalancing these purchases are sales by the CFO, assistant controller,
and sales manager
...

Since several of these sales are clustered near the beginning of November, it is

Table 8
...
This leaves the purchase of shares by the CEO: this was
the last stock purchase of the year, and the last one prior to a conference call with
investors
...

Based on this more detailed review, the investment analyst should suspect that financial results for the quarter will not be good
...
For example, stockholders may sell stock based on an immediate need for
cash
...
Furthermore, stock purchases may be based on bargain purchase options that make stock an extremely attractive deal for the buyers even if the market price is not good at all
...


MARKET VALUE ADDED
Description: This measurement shows the net difference between a company’s

market value and the cost of its invested capital
...

Formula: Multiply the number of common shares outstanding by their current

market price
...
When deriving this
calculation, be sure to use only the number of shares outstanding exclusive of any
treasury stock
...
This statement will include the
market value added measurement
...
2
...
2

Number of common shares outstanding
Common stock price
Number of preferred shares outstanding
Preferred share price
Book value of invested capital

Prior Year

Current Year

3,500,000
$5
...
00
$20,000,000

4,000,000
$7
...
93
$24,300,000

She calculates the prior year market value added:
(3,500,000 Common shares × $5
...
00 Price) – $20,000,000 Equity book value =
($17,920,000 Common market value) + ($6,538,000 Preferred book value) –
$20,000,000 Equity book value =
$4,458,000 Market value added
Using the same formula, the CFO calculates the market value added for the current year, as:
(4,000,000 Common shares × $7
...
93 Price) – $24,300,000 Equity book value =
($28,120,000 Common market value) + ($7,838,250 Preferred book value) –
$24,300,000 Equity book value =
$11,658,250 Market value added
The CFO can point out to investors that there is a net gain in market value
added of $7
...

Cautions: This calculation is a difficult one to make if a company’s stock is ei-

ther not publicly held or thinly traded, since it is difficult to obtain a market value
for any outstanding shares
...
This problem
can be reduced by obtaining an outside valuation from an appraiser or by consistently using any of a number of valuation techniques, such as the present value of
cash flows, a multiple of sales, or the fair market value of net assets
...
Also, perceived investor

Market Performance Measurements / 143

changes on an entire industry (such as changes in the price of jet fuel on the airline industry) can cause investors to drive the stock price of an individual company within that industry up or down, despite its having positioned itself to be
immune from the changes that are driving investor behavior
...
A high percentage of outstanding options to common shares
indicates a potential problem
...
More precise versions of the measurement are therefore included in the formula section that eliminate this issue
...
The formula is:
Total stock options
——————————————
Total common shares outstanding
Though this formula gives a general idea of the number of shares that may be
converted eventually through the exercise of options, a great many of them may
never be exercised because the time is nowhere near the period when they vest
...
Accordingly, the most restrictive variation on the formula only includes
those options that are in the money
...
The analyst obtains the following information:

144 / Business Ratios and Formulas

Total shares outstanding
Total options granted
Total options vested
Total options vesting in one year
Total options vesting in two years
Total options vesting in three years
Total vested options in the money

42,500,000
5,250,000
1,250,000
3,000,000
250,000
750,000
100,000

If all the outstanding options were used as the numerator in the calculation, an
options-to-common shares ratio of 12
...
4% Options to shares ratio
42,500,000 Total shares outstanding
However, only 100,000 of these options are in the money, which is a miniscule
0
...
An additional issue is that the bulk of all unvested shares
will be vested in one year, which will result in a ratio of vested shares to common
stock of 4,250,000 vested options to 42,500,000 common shares, or 10%
...
An additional issue that the analyst should explore is
whether the newly vested shares will be in the money based on their designated
exercise prices
...
For example, if only the
most restrictive measurement, which uses the total number of shares in the money,
were tracked, then it might come as a surprise if the market price of the stock suddenly jumps, thereby throwing a potentially large number of vested stock options
into the money and altering the measurement
...


COST OF CAPITAL
Description: The cost of capital is the blended cost of debt and equity that a com-

pany has acquired in order to fund its operations
...


Market Performance Measurements / 145
Formula: The cost of capital is composed of the costs of debt, preferred stock,

and common stock
...
To derive the cost of debt, multiply the interest expense associated with the debt by the inverse of the tax rate percentage, and divide the result by the amount of debt outstanding
...
These fees, premiums, or discounts should be gradually
amortized over the life of the debt, so that the amount included in the denominator will decrease over time
...
The formula is:
Interest expense
———————————
Amount of preferred stock
The calculation of the cost of common stock requires a different type of calculation
...
The risk-free rate of return is derived from the return on a U
...
government
security
...
The return related to
risk is called a stock’s beta; it is regularly calculated and published by several investment services for publicly held companies, such as Value Line
...
Given these components, the formula for the cost of common stock is:
Risk-free return + (Beta × (Average stock return – Risk-free return))
Once all of these calculations have been made, they must be combined on a
weighted average basis to derive the blended cost of capital for a company
...

The return it reported for its last fiscal year was 11
...
The company’s bonds are
currently priced on the open market at a total price of $50,800,000, its preferred
stock at $12,875,000, and its common stock at $72,375,000
...
It pays $4,625,000 in interest on its bonds, and there is an unamortized
debt premium of $1,750,000 currently on the company’s books
...
The risk-free rate of return is 5%, the return on
the Dow Jones Industrials is 12%, and Jolt’s beta is 1
...
To calculate Jolt’s cost of
capital, first determine its cost of debt, which is:
($4,625,000 Interest expense) × (1 – 0
...
8%
$50,800,000 Debt + $1,750,000 Unamortized premium
The investment analyst then proceeds to the cost of preferred stock, which is
calculated as:
$1,030,000 Interest expense
———————————— = 8
...
5 Beta × (12% Average return –
5% Risk-free return) = 15
...
3 to determine the combined cost of capital for Jolt
...
8% is a marginal improvement
over its cost of capital of 11
...


Table 8
...
8%
8
...
5%
11
...
The market rate, can help to accurately determine the assumed rate of return that investors are expecting at the moment; this is
much preferable to using the book rate for either item, since this fixes the rate of
return at the time when the shares were originally sold and gives no indication of
current market expectations
...
If sales increase and there is no change in the
stock price, then the rate of growth in sales falls within the expectations of investors
...

Formula: Divide annualized net sales by the average common stock price for the

reporting period
...

The average common stock price should be used instead of the ending stock price,
since this removes some fluctuation from the price
...
The president elects to do so by focusing solely on increases in
sales
...
To increase sales, the president allows customers to pay for their clocks within 180 days, instead of the usual 30 days, and
also offers discounts for bulk purchases
...
Unfortunately, the president’s actions so thoroughly
clog the company’s distribution pipeline with product that its sales volume in the
following year dives down to less than one-quarter of the sales level in the preceding year
...


148 / Business Ratios and Formulas
Cautions: A stock’s price is influenced by a number of variables besides sales,

such as the general trend of the stock market, profitability, and the general perception of investors in regard to the prospects of the industry in which the company is located
...
Consequently, the overall correlation between sales
and stock price is not perfect
...
For
example, a ratio that is substantially lower than the average rate for the industry
could indicate an expectation among investors that a company’s future earnings
are expected to trend lower
...
The
key point when using this ratio is that a result that varies from the industry average probably indicates a change in investor perceptions from the rest of the industry in regard to a company’s ability to continue to generate income
...


The net income per share figure is typically used on a fully diluted basis, accounting for the impact of options, warrants, and conversions from debt that may
increase the number of shares outstanding
...
The industry average price/earnings ratio for
lighter-than-air transport manufacturers is 18:1
...
87
3,875,000
$8,500,000
$2,250,000

If the analyst chooses to leave the extraordinary amount in the total net income
figure, then the following calculation will be used to derive the price/earnings
ratio:

Market Performance Measurements / 149

$32
...
However, if the analyst excludes the extraordinary gain from net income,
the earnings per share figure drops to $1
...
When incorporated into the
price/earnings formula, this change increases the ratio to 20:1, which is higher
than the industry average
...

Cautions: If a stock tends to fluctuate widely over the short term, then it is difficult
to arrive at an average common stock price that yields a valid price/earnings ratio
...

Another issue is that the net income figure can be significantly altered by the
presence of large reserves or extraordinary items that skew operating results
...

Yet another issue is that the stock price is based on a number of factors besides
net income, such as an industry-wide drop in revenue prospects, legal action
against the company, well-publicized warranty claims, the presence of valuable
patents, and so on
...


CAPITALIZATION RATE
Description: The capitalization rate is simply the reverse of the price/earnings

ratio
...

Formula: Divide earnings per share by the market price per share
...
If the capitalization rate measurement is being used to decide
whether to purchase or sell stock, brokerage and other fees required to complete
the transaction should be included in the calculation
...
This company’s
stock has experienced a considerable run-up in its stock over the past few months,
and the investor is concerned that it may have gone too high to be a valid investment
...
18, and its stock price is $159
...
This means
that its capitalization rate is 1
...
18 earnings per share, divided by $159
...
4%
...

Cautions: As was the case for the price/earnings ratio, the capitalization rate can

be skewed by the presence of extraordinary items that do not properly reflect the
earnings stream from operations
...


9
Measurements for the
Accounting/Finance
Department

T

he accounting department spends the bulk of its time processing standard transactions, such as billings, cash receipts, expense report processing, and payments to suppliers
...
There are also measurements covering the payroll, general ledger, taxation, collections, and treasury functions
...
If the
controller or CFO comes upon a measurement that shows poor accounting performance, there will be a temptation to delay release of the measurement or to alter its
calculation to make the result look better
...
Alternatively, the measures should be periodically reviewed by
someone independent of the accounting department to ensure that they are being
properly completed
...
From the accounting perspective,
this means examining incoming invoices from suppliers to see if a discount is offered, determining if the discount is economical, and scheduling it for early payment
...
Any measurement result less than 100% should be considered unacceptable
...
The information needed for the numerator is generally
simple to collect, because a typical accounting system will store the amount of the
discount in a separate line item in the chart of accounts
...
One can query the supplier database in an automated accounting
system to see which suppliers are listed as having discounts, but this will ignore
any suppliers for whom the accounts payable staff has missed the presence of discounts on their invoices
...

Also, all offered discounts with terms so poor that they should be excluded
from the denominator (since they are not viable discounts)
...
The auditors compile the information about discounts
shown in Table 9
...


Measurements for the Accounting/Finance Department / 153

Table 9
...
Consequently, they choose to exclude the noneconomically viable discount from the
numerator, since this figure should only relate to the total number of economically
viable discounts available that are noted in the numerator
...
3% Purchase discounts taken
Also, since the company’s automated accounts payable system is set up for
continuing early payments to Raster Builders (whose discount is not economically viable), the internal auditors inform the accounts payable supervisor and
controller of this problem, so that the payment record for this supplier can be
altered
...
The same problem arises
for centralized accounts payable departments that service many company locations, because invoices may be sent to outlying locations by suppliers, which
builds in a time delay while these locations send the invoices to the central accounts payable location
...
If delays are caused
by a centralized accounts payable system, then the accounting staff can contact
suppliers to have them change their “bill to” addresses to match that of the accounts payable center
...
It is most
effective when presented alongside a detailed listing of specific discount-related
payment problems, with the reasons why those discounts were missed
...
An alternative is to divide the dollar volume of payments missed by the total dollar volume of payment discounts available, which focuses attention on the presence of large missed discounts
...
To bring the issue to the attention of the controller, the assistant controller decides to calculate the percentage of payment discounts missed
...
However, the assistant controller sees that, contained within the small
number of missed discounts, is a very large dollar volume of lost discounts
...


Measurements for the Accounting/Finance Department / 155

TRANSACTIONS PROCESSED PER PERSON
Description: In the accounting department of a larger company, the bulk of the

staff is occupied with the repetitive processing of various types of transactions,
such as billing, cash receipts, and payments to suppliers
...
The number of transactions processed per
person can be applied to any repetitive transactions and tracked on a trend line in
order to see changes in efficiencies within these areas
...
The formula is:
Total number of transactions processed
———————————————————————————
Number of full-time equivalents required to complete transactions
Example: The Jester Playing Card Company has a large billing staff to handle the
thousands of invoices that it sends out to buyers of its high quality playing cards
...
The controller elects to track this efficiency on a trend line, which is shown in Table 9
...

The controller has picked a good area for improvement, since the measurement
shown at the bottom of the table reveals that the efficiency level is dropping in this
area
...
The controller can likely improve the transaction
efficiency measurement by concentrating on improving the other staff to the point
where the new part-time position can be eliminated
...
2

Number of invoices issued
Total full-time billing staff
Total half-time billing staff
Total full-time equivalents
Number of invoices processed per person

January

February

March

1,950
3
1
3
...
0
531

2,005
3
2
4
...
If a staff person is required to complete several types of transactions during a measurement period, then it becomes difficult to clearly identify the time
required to complete each type of transaction
...
Though this may at first appear to be a reasonable method for deriving
some general level of staff efficiency, it assumes that the mix of transactions stays
exactly the same from period to period
...
This results in an efficiency measurement that reveals no relevant information
...
However, it did not measure
the number of transactional errors, which can climb dramatically if the focus is
only on pushing through the largest possible volume of transactions
...

Also, the error rate can be used by itself as a valid measure of departmental performance, since error correction can tie up the services of a multitude of senior accounting staff, who can be better used for other activities
...
Be careful to match
transactional errors to the same period in which the transactions occurred; it is
common for errors not to be spotted and corrected until a later period, so they are
compared to total transaction volumes for the later period that may be quite different from the volumes in the period when they occurred
...
The relevant information is in Table 9
...

The accounting manager sees that the highest error rate is in the payables transactional area, with billings being a close second
...
3
Processes
Billings transactions
Cash receipts transactions
Payables transactions

No
...
of Total
Transactions

140
30
210

1,190
2,130
1,430

Transaction Error
Rate
11
...
4%
14
...

Cautions: This is an excellent measurement
...
For example, a large number of incorrect billings that are caused by an easily
fixed change to the pricing file may make the proportion of billing errors look
large, while a smaller number of errors related to cost allocations, which can be
difficult to spot and correct, may actually represent a larger time commitment to
correct
...


AVERAGE TIME TO ISSUE INVOICES
Description: The accounting department can have a considerable impact on the

timing of cash receipts, based on its ability to issue invoices to customers as soon
as possible after shipments or services have been completed
...
This can put a company in a dangerously low cash flow position, or at least reduce the amount of interest income
it can earn on its excess cash
...

Formula: Subtract the shipment date from the invoice date for each invoice, and

summarize the number of days required for all invoices issued during the period
...
The number of days
on weekends and holidays can be included or excluded, depending on a company’s emphasis on issuing invoices even during these traditional days off
...
The formula is:
Sum of invoice dates – Sum of shipment dates
———————————————————
Number of invoices issued

158 / Business Ratios and Formulas

Table 9
...
The controller believes that the problem lies in the slow
transfer of paperwork from the shipping department to the billing department
...
She takes a random sample of five shipments and their associated invoices, which are shown in Table 9
...

The total number of days required for invoicing is 27 (the total of the Days
Delay column)
...
4 Average days to issue invoices
5 Invoices issued
The controller can go a step further and calculate the amount of cash that would
otherwise be available for investment during those 5
...

Cautions: As noted in the Formula section, the calculation can be thrown off if

weekends or holidays are included, since their inclusion can result in a calculation
that shows an inordinate length of time between shipment and invoicing
...
Therefore, either discount these days from the
calculation or assume that invoices will be issued on all days, irrespective of the
presence of a holiday or weekend
...
The expense report turnaround time is critical to employees who have
paid for company expenses on their own credit cards and need funds back in short

Measurements for the Accounting/Finance Department / 159

order so that they can pay the credit card balances
...

Formula: Subtract the date when an expense report was received by the account-

ing department from the date when payment was distributed to the employee
...
To prove this point, the manager assembles the data in Table 9
...

The manager finds that the average delay in paying employees for their expense reports is 25
...

Cautions: There are several ways in which this measurement can be altered
...
This makes it difficult to determine the exact date on which the accounting
staff received the report for processing
...
The expense report routing can also be
altered so that it goes to the accounts payable staff first and then to the supervisor
for approval; by requiring the accounting staff to pay the expense report after a
predetermined minimum time period, irrespective of the receipt of supervisory approval, employees will receive their payments on time
...
A company can use automated clearing
house (ACH) transfers to avoid these delays
...
5
Name
B
...
Deckers-Whidley
P
...
Quark
J
...
However, few companies go to the trouble of determining the annual
cost of this processing on a per-person basis
...
For these companies, the payroll transaction fee per employee measurement is a valuable tool
...
Be sure to exclude from the total fee any charges
that cannot be directly related to individual employees, such as special reports or
payroll shipping charges
...
The payroll function is the main accounting activity
...
6), which are all
based on the processing of a single biweekly payroll
...
The company has requested 401(k) and sick time reports
once a month
...
Based on
these volume considerations, the total cost of the current provider is:

Table 9
...
00
$
...
50
$12
$10
$2
...
25
$
...
65
$5
$5
$3
...
00 × 120 employees × 26 payrolls
= Envelope stuffing fee of $
...
50 × 120 employees ×
26 payrolls
= Garnishment fee of $2
...
25 × 120 employees × 26 payrolls
= Envelope stuffing fee of $
...
65 × 120 employees ×
26 payrolls
= Garnishment fee of $3
...
In this case, the variable

162 / Business Ratios and Formulas

payroll cost per employee is $42
...
48 if
the competitor is used
...
By separating these costs, the pricing strategies of payroll suppliers can be
determined, some of whom advertise low fixed fees to attract new customers, but
who have so many extra per-employee fees that the total cost is higher
...
Consequently, this measurement should be used on a trend line to measure the
accounting department’s ability to gradually reduce the required time over a period of months
...

Formula: Subtract the statement issue date from the first day of the month fol-

lowing the reporting month
...
The time
needed to complete the last set of financial statements was 10 days
...
Table 9
...


Table 9
...
Logically, the controller elects to cut into this series of dependencies
by focusing on cutting the inventory cut-off to one day and shifting some of the
variance analysis into the last week of the preceding month, while also imposing
a minimum variance cutoff size and thereby reducing the number of accounts
being reviewed
...

Cautions: An accounting manager can use this measurement to show an ongoing

improvement in the speed of financial statement completion, but at the cost of cutting back on accompanying reports and analyses, which are an integral part of the
statements
...

There are several actions required to improve the speed of financial statement
production, such as achieving an instantaneous inventory cutoff, creating an accurate perpetual inventory database, and performing some variance analysis prior
to period-end
...


PERCENTAGE OF TAX FILING DATES MISSED
Description: Many types of tax forms can be delayed by filing for extensions, a

practice that gives tax accountants a great deal of leeway in completing tax returns
...

However, there are also many cases where lesser returns, such as sales tax payments or franchise tax returns, must be filed by a specific date, or else penalties
will be incurred
...
If the measurement shows
that the percentage continues to increase over time, it is possible that the tax staff
is understaffed and so is falling increasingly behind in its ability to complete tax
filings
...
An alternative is to focus on the total dollar volume of tax penalties paid, which should include both penalties and interest
charges
...
8

Number of states added
Number of late filings
Total returns filed
Percentage of tax filings missed

2000

2001

2002

5
3
42
7%

5
11
57
19%

13
40
96
42%

Example: The Albatross Shoe Company is expanding its operations from the

central United States to the eastern seaboard
...
The controller wants to determine if an additional staff person should be added to the department, which currently employs three people
...
8
...
Furthermore, the percentage of missed filings was actually increasing even
before the addition of these extra states
...

Cautions: There are many types of tax returns, each having different types of

penalties
...
Given the disparity in potential liabilities, it may be helpful to eliminate all
small-penalty tax returns from the equation, focusing only on those that can result
in large penalties
...
If the purpose
of the measurement is to determine the proportion of returns that will result in
penalties, then those returns with extensions should be excluded; however, if the
intent is to determine the proportion of returns that are late because of a labor
shortage in the taxation department, then they should be included
...
The result can be sales of a product that makes no
money, or for which there is a cash drain whenever one is sold
...

The proportion of products costed prior to release is an easy measurement to make
management aware of this issue
...
Of particular
concern is establishing the exact date on which product costs must be completed—it can be the date of product release or substantially sooner so that the design teams will have sufficient cost-related input to alter their designs as needed
...
The cost accountant claims that there is no need to issue cost reports on each
one, since they all use the same design platform
...
The controller asks the internal audit staff to review the situation
...
During that period, the company produced 18 new sneaker designs,
of which only the first three had costing reviews completed by the cost accountant
...
The controller promptly fires the cost accountant and decides to build this measurement
into the performance appraisal of the next person hired into the position
...
However, the task is still necessary to ensure that there are no product
variations that will result in inadequate margins
...


INTERNAL AUDIT SAVINGS TO COST PERCENTAGE
Description: The internal audit staff provides a number of crucial functions, such

as preventing or detecting fraud, passing judgment on the controls used for new
accounting systems, and recommending changes that will result in lower costs
...
Compare the sum total of
all recommended cost savings by an internal audit group to its operating cost in

166 / Business Ratios and Formulas

order to arrive at a proportion of savings to costs
...

Formula: Divide the total amount of savings recommended by the internal audit

staff by the total internal audit expense, which should include all departmental
costs, such as salaries, payroll taxes, travel and entertainment, and support costs
...
The measurement is:
Internal audit recommended savings
———————————————
Internal audit expense
Example: The audit committee of the Amalgamated Munitions Factory is concerned about the total cost of the internal audit department
...
The CFO
explains that the department does not just search for fraud and review internal controls
...
Eliminate half of the accounts payable staff by installing a preexisting automated three-way matching system for payable transactions, saving $185,000
...
Outsource the telephone support function, eliminating one in-house position,
saving $29,000
...
Improve the accuracy of bills of material, thereby cutting excessive purchasing
costs and eliminating excess parts from the warehouse, saving $52,000
...
The proportion of internal audit savings to costs was calculated as:
Internal audit recommended savings
——————————————— =
Internal audit expense
$185,000 Payables elimination + $29,000 Phone elimination +
$52,000 Bill accuracy
—————————————————————————— =
$285,000 Audit payroll + $104,000 Other audit expenses
68
...

Cautions: If this measurement is used as a key performance indicator for the in-

ternal audit group, then they will insist on conducting reviews that focus exclusively on potential cost savings, rather than also conducting control reviews that
could potentially save a company much more money over the long run by preventing fraud
...

Also, the recommended savings listed in the numerator can be wildly inflated
or impractical, since they are strictly recommendations, and may never be tested
for their validity
...


INTERNAL AUDIT EFFICIENCY
Description: The internal audit department’s efficiency can be difficult to measure,
since a significant finding, such as a fraud situation, may require much more staff
time than was originally planned
...
If additional work is required, such as may
be caused by a fraud investigation, then it can be scheduled as a new project and included in an orderly manner into the work schedule of the department
...

Formula: Divide the number of internal audits completed by the total number of

internal audits planned
...
The formula is:
Number of internal audits completed
———————————————
Number of internal audits planned
Example: The Spiffy Soap Company, a large-volume soap producer, has a large

internal audit department that performs over a hundred audits per year
...
He scheduled 109 audits at the beginning of the year
...
At the end of the year, three jobs were still open; they
had accumulated 142 hours of work out of 310 scheduled hours
...
17 Beginning hours completed × 5 audits = 0
...
46 Ending hours completed × 3 audits = 1
...
00
Number of equivalent audits completed = 93
...
23 Internal audits completed
——————————————
109 Internal audits planned
= 85
...
Consequently, the measurement must be supplemented
by a qualitative review of the results of all completed audits
...
All of these comparisons are needed in order to determine how bad debt levels are being controlled
...

Formula: Divide total bad debt dollars by the total amount of accounts receivable
...
An alternative approach is to divide total bad debt dollars by total annualized credit sales; however,
if this approach is used, then the numerator will only be comparable to the denominator if the bad debt figure is annualized, either by using the last 12 months
of bad debts on a rolling basis, or by annualizing the amount of bad debts incurred
over a shorter period
...
9

Bad debt expense
Annualized credit sales
Bad debt percentage
Accounts receivable
Receivable turnover

Quarter 1

Quarter 2

Quarter 3

Quarter 4

$100,000
$1,250,000
8%
$125,000
10

$112,000
$1,400,000
8%
$156,000
9

$113,200
$1,415,000
8%
$177,000
8

$120,400
$1,505,000
8%
$215,000
7

Total bad debt dollars recognized
——————————————
Total credit sales
Example: The auditors of the Night Vision Company, maker of night vision baby

monitors, want assurance that the company has reserved a sufficiently large bad
debt reserve to cover its year-end accounts receivable
...
9
...
However, the accounts receivable turnover rate has been dropping throughout the year
...
If the accounts receivable turnover at year-end were 10 turns, as they were during the first quarter
of the year, then the accounts receivable balance should be only $150,500
($1,505,000 annualized credit sales divided by 10 turns), as opposed to the
$215,000 listed on the books
...

The auditor’s next action should be a detailed review of all overdue accounts receivable, to see if specific bad debts are not being recognized
...
The key problem is that the numerator is composed
of the total bad debt dollars recognized
...
Another problem is that
previously recognized bad debts that are later paid by customers must be backed out
of the bad debt expense, rather than being reinvoiced as new sales
...


PERCENT OF RECEIVABLES OVER XX DAYS OLD
Description: A company can precisely tailor its accounts receivable measure-

ments by calculating only that portion of receivables that are older than a specific
date
...
For example, if the traditional
payment period is 65 days, then it is difficult to tell from a days of receivables
measurement of 60 days if all invoices are not quite due for payment, or if some
proportion of them are well past the customary payment date
...

Formula: Divide the total dollar amount of all outstanding receivables exceeding

a user-specified age by the total amount of all accounts receivable outstanding
...
Otherwise, an old bad debt may still appear in the numerator without an offsetting credit; the credit is usually much newer than the debt
and so will be excluded from the date range used to select transactions for the numerator
...
The delay
is caused by the cash shortage of skiing retailers, who must liquidate their ski
stocks prior to Christmas before they can pay their suppliers
...
The collections manager decides that any invoice
more than 95 days old is a potential bad debt and calculates the percentage of receivables over 95 days old, comparing the measurement to the results for the same
period in the preceding year
...
10
...
However, the $142,000 of overdue accounts is still
substantial, so the collections manager gets to work identifying the specific problem accounts and contacting them about payment
...
For example, if a large unpaid invoice is 69 days old, the measurement can be set at anyTable 9
...
5%

$121,000
$2,881,000
4
...
This problem can be avoided by
consistently using the same number of days in the measurement for many periods,
thereby also giving a better period-to-period comparison of results
...
This
requires constant monitoring of collection results and replacement of those who
are not performing above a minimum level
...
The measure can be used to monitor the performance of either an internal collections staff or that of a collections agency to
which accounts have been assigned
...
However, since the numerator will include the collection agency’s fee
(which is subtracted from any funds collected), it will tend to show an unusually
low percentage; one may consider removing the fee deduction when running the
calculation in order to get a better idea of the collection agency’s performance
...

Example: The Meek Furniture Company has hired the Irascible Collection
Agency to collect all of its accounts receivable that are more than 90 days old
...
In the past year, Meek
passed $83,500 in 90-plus day receivables to Irascible, which returned $28,250 to
Meek as a result of its activities
...
The formula is:

Cash received from collection agency / (1 – Collection fee percentage)
————————————————————————————— =
Total accounts receivable assigned to collection agency

172 / Business Ratios and Formulas

$28,500 Cash received / (1 – 1/3 Collection fee)
———————————————————— =
$83,500 Assigned to collection agency
51% Collected of dollar volume assigned
Cautions: This measurement can yield misleading results if the accounts receiv-

able assigned to a collection agency or in-house collections staff are not compared
to cash receipts related to those same receivables
...
If this problem is not addressed, a common
result will be an excessively low percentage collected, because cash receipts are
being compared to additional new receivables as well as the original base of receivables from which they were collected
...
This is caused by inefficiency within the collections
staff
...

Formula: Summarize the dollars of cash applied on the day of cash receipt (which

should be available in the cash receipts journal) by the total dollars of income on
the day of receipt (which comes from the bank deposit slip for that day)
...
The formula is:
Dollars of cash receipts applied on day of receipt
—————————————————————
Total dollars of incoming cash on day of receipt
Example: Today’s cash receipts at the Holiday Health Spa include $1,200 in
cash, $6,025 in checks, a $500 wire transfer, and a $3,250 automated clearing
house (ACH) receipt
...
A
total of $10,325 was applied to specific accounts receivable on the day of receipt
...
First, include
the wire transfer in the calculation, on the grounds that it is the accountant’s responsibility to research the cash receipt and appropriately record it
...
The amount of these funds must then be recorded in a holding
account until the customers can be contacted about the problem
...
However, one can also include this
cash in the measurement, on the grounds that this will force the cash applications
staff to rapidly resolve the problem with customers in order to achieve the highest
possible measurement result
...
It is used by the purchasing department as a negotiating tool so that a company can receive a net return on early payments to suppliers
...
Further, the sales staff uses the calculation in its dealings with the
purchasing staffs of other companies, who are also interested in obtaining better
early payment discounts
...
This is the number of days between the end of the early payment period and
the date when the payment would normally be due at full price, divided into 360
days
...
Next, subtract the offered discount percentage from 100%, and divide the
result into the discount percentage
...
Finally, multiply
the effective interest rate by the proportion of the full year to which the discount

174 / Business Ratios and Formulas

period applies
...
The formula is:
Discount %/(100-Discount %) × (360/Full allowed payment days –
Discount days)
Example: A supplier of the Newman Astronautics Company is offering early
payment terms of 2/15 net 40, which is a discount of 2% if paid within 15 days,
with regular payment due after 40 days
...
The accounts payable manager needs to decide if it is economically sensible to take advantage of the discount
...
0204 × 14
...
4% Cost of credit
Since the cost of credit of 29
...
The accounts payable manager authorized
taking the early payment discount
...

In reality, taking a discount tends to be an incremental decision related to the immediate cost of invested funds
...
This means that the incremental investment trade-off is a few percent of interest earned in the money
market fund, rather than the much higher cost of capital for the entire company
...
Others have considerable cash reserves that are being held for
larger expenditures, such as acquisitions
...
The earnings rate on invested funds
is a good measurement for tracking the performance of this activity
...

Because the amount of funds invested may fluctuate substantially over the measurement period, the average value can be used
...
The formula is:
Interest earned + Increase in market value of securities
———————————————————————
Total funds invested
Example: The Rake and Mow Garden Centers corporate parent is earning a
considerable return from its chain of small-town garden centers
...
It had
$5,500,000 of invested funds at the beginning of the year and $6,200,000 at the
end of the year
...
Its total earnings rate on invested
funds was:

Interest earned + Increase in market value of securities
——————————————————————— =
Total funds invested
$75,000 Interest earned + $132,000 Increase in market value of securities
—————————————————————————————— =
($5,500,000 + $6,200,000) / 2
3
...

The board of directors must realize that a reasonable, but not spectacular, amount
of return is perfectly acceptable, because a company should focus its investment
strategy on other goals as well, such as liquidity and minimal loss of principal,
which tend to result in lower rates of return
...
It is useful to compare this
cost to either the total amount of transactions or the amount of funds invested (in
case a broker is involved)
...


176 / Business Ratios and Formulas
Formula: If a company is interested in the cost of brokerage transactions, then it

should divide the total amount of broker fees charged by the total amount of funds
invested in the related account
...
The formula is:
Bank / broker transaction fees charged
————————————————————
Number of bank / broker transactions processed
Example: The Universal Soccer Sports Company is evaluating the performance

of its broker, who handles all transactions for its investment account
...
In the past year, the broker charged $23,625 as
a management fee, as well as $16,525 for transactional fees associated with the
purchase and sale of securities
...
4% Brokerage fee percentage
Cautions: There is a great deal of competitive fee information available from bro-

kers who are interested in obtaining a company’s investment business
...

The same problem applies to the brokerage fee percentage used for banking
transactions because there are many types of bank fees, each of which can be
compared to those of other banking institutions to see if they are reasonable
...
When these fees are included in the measurement, they tend to water down
the impact of other, larger-fee items
...


Measurements for the Accounting/Finance Department / 177

BORROWING BASE USAGE PERCENTAGE
Description: The borrowing base usage percentage is an excellent measure for

keeping track of the amount of debt that a company can potentially borrow, based
on that portion of its accounts receivable, inventory, and fixed assets that are not
currently being used as collateral for an existing loan
...
It is particularly useful within a cash budget, indicating not only the amount of any potential
cash shortfalls but also the ability of the company to cover those shortfalls with
collateralized debt from existing assets
...
Then multiply the current amount of inventory, less the obsolescence reserve, by the allowable borrowing base percentage (per the loan document)
...
It is also possible to include in the denominator
the amount of fixed assets (net of a borrowing base percentage), but many lenders
do not allow a company to use fixed assets as part of its collateral, on the grounds
that fixed assets are too difficult to liquidate
...
The
market for its products is gradually declining, and the president is searching for alternative products that will shift the company into a more profitable situation
...
Under the terms of the loan, the borrowing base percentage
is 70% for accounts receivable, 50% for inventory, and 20% for fixed assets
...
11
...
11
Account

Amount

Accounts receivable
Inventory
Fixed assets
Accumulated depreciation
Loans

$350,000
$425,000
$205,000
–$65,000
$250,000

Note that the fixed assets borrowing base calculation was net of the accumulated depreciation figure; otherwise, the borrowing base would not properly reflect
the reduced resale value of older fixed assets
...
5% Borrowing base usage
The president sees that about one half of the total borrowing base has been used
to collateralize existing debt levels
...

Cautions: This measurement is highly recommended
...


10
Measurements for the
Engineering Department

T

his chapter focuses on the measurements that can be used to determine the performance of the engineering department, especially of its new-product design
function
...
Instead, the formulas cover such operational issues as bill of material accuracy, reuse of parts in
new product designs, and ability to reach target costs
...
The bill of materials should specify exactly what components are needed to build a product, plus the quantities required
for each part
...
An accuracy

179

180 / Business Ratios and Formulas

Table 10
...

Formula: Divide the number of accurate parts (defined as the correct part num-

ber, unit of measure, and quantity) listed in a bill of material by the total number
of parts listed in the bill
...
Its engi-

neering group has just released the bill of materials for a new plastic chair
...
Table 10
...

The production manager’s review reveals that there are two mistakes in the bill
of materials
...
In both cases, using the bill of materials would have resulted in a
considerable overordering of product labels and boxes for the product
...

Cautions: Though the minimum acceptable level of accuracy is 98%, this is an

area where nothing less than 100% accuracy is required to ensure that the production process runs smoothly
...

The timing of the release of the bill of materials is another problem
...
Measuring the timing of the bill’s release as well as its accuracy can
avoid this problem by focusing the engineering staff’s attention on it
...
By multiplying a product’s labor routing by the number of
units to be produced, the production planning staff can tell how much direct labor
and machining time is needed to complete a production run
...

Formula: Summarize the total number of correct machining times and machine

codes in each labor routing, and divide by the total number of line items in the
routing
...
Having one or the other correct does not
mean that the entire line should be listed as correct for the purposes of the calculation
...
It requires a number of production steps to complete, as outlined in the
following labor routing
...
Further investigation reveals that the 120
minutes of time listed for the paint shop in step 8 is too low by 40 minutes
...


Step Number

Work Station

Minutes

1
2
3
4
5
6
7
8
9
10

Kitting
Hole punch
Riveting
Quality station
Burnishing
Label station
Electrical
Paint shop
Quality station
Boxing

25
15
40
10
60
5
20
120
10
5

182 / Business Ratios and Formulas
Cautions: The level of precision required for a labor routing is especially impor-

tant when very short processing times are required for each production station,
since a small error in an already-small number can have a major impact when multiplied by a large production run
...
Consequently, the calculation of labor routing accuracy should be based on
getting the estimated time correct to within a certain percentage of the actual time
...


PERCENTAGE OF NEW PRODUCTS INTRODUCED
Description: The percentage of new products introduced is of great importance in

high-fashion consumer markets, where existing products may last for only a few
months before being replaced
...
Thus, the applicability of this measure will depend on the competitive situation in which a
company finds itself
...

The formula is:
Number of new products introduced in the period
—————————————————————————
Number of products available at the beginning of the period
Example: The VibroMatic Massage Company has been producing the same massage chair for the past decade
...
Accordingly, the president bases the bonus plan for the engineering manager on the
percentage of new products introduced
...
2
...
2
Design
Micro massage chair
Massage stool
Mongo deluxe massage
Foot massage bolster
Office massage chair

Status
In production
In tooling
Design approved
In design
In design

Measurements for the Engineering Department / 183

The company had a total of five production models at the beginning of the measurement period
...
The president reviews the engineering manager’s job description and concludes that those
job responsibilities end at the design stage, after which other people are responsible for tooling and production
...
This results in the following percentage of new products introduced:
3 New products introduced in the period
————————————————————— = 60%
5 Products available at the beginning of the period
Cautions: The design team being measured may attempt to define minor product

variations as new products
...
To keep this from happening, specify that only those products using an
entirely new product platform, or which use a minimum percentage of entirely
new parts, will be considered new products
...
This
problem can be avoided by using the percentage of sales from new products measurement, which focuses management attention on the practical results of new
product development
...
A variation is to use

in the numerator the sales from any products developed within a predefined number of years; for example, one consumer products company measures the percentage of new sales generated by products that have been developed within the past
three years
...
The basic formula is:
Sales from new products
———————————
Total sales
Example: The Tuff Man Exercise Equipment Company is engaged in rapidly

broadening its lineup of weight lifting machines for the home market
...
3
...
3
Equipment Name
Squat rack
Bench press
Preacher bench
Lat pulldown
Quad extension
Total

New/Existing

Sales

New
New
New
Existing
Existing
—

$138,000
$208,000
$54,000
$192,000
$147,000
$739,000

Based on the information in the table, the controller calculates the percentage
of sales from new products as follows:
Sales from new products
—————————— =
Total sales
$400,000 New product sales
———————————— =
$739,000 Total sales
54% Sales from new products
Cautions: The key problem with this measurement is the definition of a new

product
...
For example, specify that only those products containing at least
25% new parts can be designated new products or only those that use an entirely
new design platform
...
This
can result in an extraordinary number of parts to keep track of, which entails additional purchasing and materials-handling costs
...
This approach
leverages new products from the existing work load of the purchasing and materials-handling staffs, and has the added benefit of avoiding an investment in inventory for new parts
...


Measurements for the Engineering Department / 185
Formula: Divide the number of new parts in a bill of materials by the total num-

ber of parts in a bill of materials
...
If so, there are fewer
parts to include in the calculation, making the measurement much easier to complete
...
The manager complains to the president that the fault does not lie with him but rather with the engineering department, which persists in issuing flashlights whose components are
entirely new, resulting in rampant increases in the number of components kept in
stock
...
The bill of materials for one of
the company’s new flashlight models can be seen in Table 10
...

Based on the information in the table, the performance measure for this single
product would be:
3 New parts in bill of materials
————————————— = 30% New parts used in new products
10 Parts in bill of materials
Cautions: Engineers may argue against the use of this measurement on the
grounds that it provides a disincentive for them to locate more reliable and/or less
expensive parts with which to replace existing components
...
4
Component

Unit of Measure

Quantity

New/Used

Casing
Tie ring
Lanyard
Cone
Quartz lens
Bulb
Spring
Contact end
Label
Box

Each
Each
Each
Each
Each
Each
Each
Each
Each
Each

1
1
1
1
1
1
1
2
1
1

Old
New
Old
Old
Old
Old
Old
Old
New
New

186 / Business Ratios and Formulas

increases in the level of quality
...


PERCENTAGE OF EXISTING PARTS REUSED IN NEW PRODUCTS
Description: The inverse of the preceding measurement can be used to determine
the proportion of existing parts that are used in new products
...

This variation is used by companies that have compiled an approved list of parts
that are to be used in new product designs, which is a subset of all existing parts
...

Formula: Divide the number of approved parts in a new product’s bill of materi-

als by the total number of parts in the bill
...
The
formula is:
Number of approved parts in bill of materials
———————————————————
Total number of parts in bill of materials
Example: The Sticky Thought Tape Dispenser Company has just issued a new

executive style tape dispenser
...
What is the engineering department’s performance in using existing parts? The answer is:
12 Approved parts in bill of materials
———————————————— = 60% Existing parts reused in new
20 Parts in bill of materials
products
Cautions: Since a complex product will probably contain one or more subassemblies rather than individual components, verify that selected subassemblies
are also on the approved parts list; otherwise, subassemblies will be rejected for
the purposes of this measurement
...
By fostering
such a plethora of models, the companies have run into difficulties with too many

Measurements for the Engineering Department / 187

production lines, each of which is tooled to only manufacture one model
...
This measurement is designed to bring this problem to the attention of management
...
The formula is:
Total number of distinct products
——————————————
Total number of design platforms
Example: Tongan Motors, the massive automobile manufacturer who conveniently ships to anywhere on the Pacific Rim from its Pacific island base, is suffering from an overabundance of design platforms
...
2 products per platform
...
0:1
...
For example, the same product in 10 different colors is still just
one product, while the basic and deluxe models of a product both probably start
with the same essential product design, and so can be termed a single product
...


PERCENTAGE OF PRODUCTS REACHING MARKET BEFORE
COMPETITION
Description: A common problem is for the engineering department to be so proud
of its new products that it fails to release its designs until they become works of
art
...
The percentage of products reaching market before the
competition can be measured to see if this is a problem
...
The formula is:

Number of products released before competition
————————————————————
Total number of products released

188 / Business Ratios and Formulas
Table 10
...
If so, an easier
measurement is to focus on the number of products released on or before their targeted dates
...
They set up Table 10
...

Based on the table, the design team must have been spending too much time in
the gym, since they only made one of the five release dates
...
There may be problems in procuring parts, which is the responsibility of the purchasing staff; manufacturing flaws that must be resolved by
the production staff; and delivery issues for which the distribution employees are
responsible
...
To avoid this problem, the second of
the two formulas, which focuses on meeting a designated design release date, focuses attention squarely on the efforts of the engineering staff
...
The key focus
of the product design teams then becomes the construction of a product that meets
the predetermined target cost
...

Formula: Divide the total of actual expected product costs by the total amount of

targeted costs
...
The reason for this extra
wording is that component costs can change drastically if assumed volumes vary
...
The formula is:
Total of actual product costs
————————————
Total of target costs
Example: The engineering manager for a copier design team is conducting a
postdesign review of the team’s performance
...
The manager has obtained the information in Table 10
...

The measurements in the table show that the design team was on track at the first
design milestone by keeping actual expected costs at a level 25% higher than the
final target cost
...
More active management of the design
process after the second milestone might have prevented this problem from arising
...
A design team can achieve a target cost and issue a completed
product design, but if its associated warranty and scrap costs are too high, the lifetime cost of the product to the company will exceed the initial target cost
...


Table 10
...

Another issue is that a design team is usually required to meet increasingly
stringent costing targets as it moves closer to the final approval of its product design
...
Consequently, it makes sense to calculate this measurement at
every milestone and compare it to the target cost at that point, rather than waiting
until completion of the entire project to see if the costing goal was attained
...


WARRANTY CLAIMS PERCENTAGE
Description: The reasons why a product may be returned under warranty can be

traced to a number of causes, such as poor production methods and low-quality
materials, that have nothing to do with the engineering department
...
If a significant proportion of warranty claims are caused by this problem,
then the warranty claims percentage should become part of the measurement package for this department
...
A variation on this calculation is to categorize warranty
claims by underlying cause, so only those warranty problems arising from engineering issues are included in the numerator
...
The
company manufactured this product during the six months leading up to the summer selling season, after which it stopped production, and it does not plan to begin
again until the end of the year
...
The total number of units produced was
183,000, and the number of claims filed thus far is 1,897
...
The production manager should consider marking the product differently in each successive year, so that returned
products can be easily associated with a specific production year
...
To obtain a measurement that
properly relates the amount of units sold and the number of warranty claims, the
measurement period should comprise several months
...
This is a particularly useful measure when there is a large backlog of design projects, and management is keen on
reducing design times to accommodate them all
...


This measure can also be subdivided into the design intervals for the product itself,
the required tooling, and the production process design
...

There are many separate workout stations in the prospective product line, and the
president wants to make sure that they are all completed on time
...
7, which sets a design time budget for each item of equipment and compares it to the actual time from design inception to completion
...

Cautions: The design process may require approvals by departments outside the

engineering area, which means that the completion date is outside the engineering

192 / Business Ratios and Formulas

Table 10
...
Also, some products are revised so frequently
that there is little separation between the initial design completion date and the immediate commencement of work on product upgrades and replacements
...
The percentage of floor space utilization is a useful measure for
determining its success in these design efforts
...
Of the three items listed in the numerator, the
one that sparks the most argument is the amount of space required for materials
movement; a company can potentially eliminate much of the space currently occupied by all types of inventory, which can be a very large proportion of all production floor space
...
By comparing the existing and optimal figures, the industrial engineering
staff can determine whether it should embark on just-in-time systemic changes to
achieve the indicated space savings
...
8

Space used by machinery
Space used by operators
Space used for materials
Total floor space
Percentage of floor space utilization

Current

Theoretical

12,000
2,500
7,500
25,000
88%

8,000
2,500
2,500
25,000
52%

compact manner
...
8 regarding information about floor space
utilization
...
However, the manager should also mention the potential savings of
5,000 square feet in materials storage space to the logistics department, so that
they can work on this area of improvement, as well
...
Also,
some companies may want more open facilities for marketing reasons, since this
configuration looks better when taking customers through the plant
...
If a company’s production area is highly specialized or incapable of being
segregated for other uses, it may not make sense to pursue a consolidation of floor
space
...
These areas are all central to the smooth functioning of a company’s production processes
...
The 26 measurements
described in this chapter are intended to address the key operational aspects of logistics and should be measured on a trend line to ensure that management can spot
operational difficulties as soon as they arise
...
To
avoid this, the logistics staff must ensure that the jobs listed on the production
schedule are completed in an orderly manner and in the scheduled sequence and
quantities
...

Formula: Divide the number of scheduled jobs completed during the measure-

ment period by the total number of jobs scheduled for completion
...
In such cases, it may be more accurate to divide the number of completed production tasks within each scheduled
job by the total number of scheduled tasks for all jobs
...
Each computer takes roughly three months to build when its production
schedule is precisely followed
...
The logistics manager has recently put
a stop to this behavior by denying all nonproduction personnel access to the manufacturing facility, and now needs to prove the point by showing the before-andafter monthly production schedule accuracy
...
1
...
1

Total scheduled production tasks completed
Total production tasks scheduled
Production schedule accuracy

Before

After

29
67
43%

43
59
73%

Measurements for the Logistics Department / 197

The table shows a decisive improvement in schedule accuracy, which the logistics manager uses to permanently block the product managers from interfering
with the production process
...
Though some provision can be made for such changes
within the schedule, these intrusions will occur, and they will impact the schedule’s accuracy
...
Under this calculation, the point at which
the carrying cost of inventory equals its ordering cost can be derived
...
Note the problems with this
approach in the Cautions section
...
Then divide this result by the carrying cost per unit,
and calculate the root of the result
...
The formula is:
The root of ((2 × Total usage in units × Cost per order)/Carrying cost per unit)
Example: The Billings Pool Table Company buys a variety of slate table tops for

its various models
...
The economic order quantity (EOQ) calculation for the slate top for the topof-the-line Grande model is based on the following information:
Annual usage in units
Ordering cost per order
Insurance cost per unit
Storage cost per unit
Interest cost per unit
The EOQ formula is:

125
$25
$35
$80
$85

198 / Business Ratios and Formulas

The root of ((2 × Total usage in units ×
Cost per order) / Carrying cost per unit) =
The root of ((2 × 125 Units usage ×
$25 per order) / $200 Carrying cost per unit) =
5
...
Also, actual order quantities allowed by suppliers may be so different from the calculated EOQ that the logistics staff has no
choice by to diverge from the calculated best purchase quantity
...
Also, a material requirements planning system may reveal that a
component has no required use in the production schedule, in which case no additional order is required, no matter how low the existing inventory levels may
drop—an issue that is not included in the basic EOQ formula at all
...


NUMBER OF ORDERS TO PLACE IN A PERIOD
Description: The purchasing manager needs to have a general idea of the number
of orders that the purchasing staff will be placing within a given time period, so
that the departmental headcount can be adjusted to match purchasing needs
...

Formula: Divide the total usage in units for a selected time period by the eco-

nomic order quantity, as shown in the preceding section
...
Its purchasing manager is reviewing vacation requests from the staff and wants to know when the largest number of
purchase orders are expected to be placed in the coming year
...
2 by quarter
...
Consequently, the manager decides to limit the number of vacation hours that will be
allowed through that time period
...
2

Usage in units
EOQ
Number of orders to place

Quarter 1

Quarter 2

Quarter 3

Quarter 4

120,000
275
436

158,000
275
575

143,000
275
520

117,000
275
425

Cautions: This measurement assumes that the effort required to place any order

is the same
...
Consequently, it is better to run this calculation
for different types of orders, to gain a more accurate understanding of the total
projected amount of time required to place them
...
This is a useful tool for the production scheduling staff, which needs
to know the most cost-effective size for which production runs should be scheduled
...

Formula: Multiply the total unit demand of a product by two, and then multiply

the result by the run setup cost
...
Of particular importance is the variety of
costs that can be included in the carrying cost per unit, which includes incremental materials handling costs, the cost of extra warehouse space and storage
racks to contain it, damage caused by storage, insurance fees, and property taxes
...
Its
production scheduling manager wants to determine the optimal production run
size for this product
...
Its economic
production run size is as follows:

200 / Business Ratios and Formulas

The root of ((2 × Total unit demand × Run setup cost) / Carrying cost per unit) =
The root of ((2 × 150,000 × $425,000 Setup cost) / $32 Cost per unit) =
63,122 Units
Cautions: This measurement applies only to situations where production runs

are being made to stock, rather than to fill orders
...

Also, the theory of the economic production run size has been challenged by the
just-in-time (JIT) manufacturing concept, which holds that the ideal run size is a
single unit, which can be achieved by lowering the setup time to a minimal amount
...
The end result of
these systems is a very high number of raw material inventory turns
...
The inventory value at the end of the period can
be arbitrarily high in relation to average inventory levels throughout the measurement period, so an average value can be used instead
...
Since its sales tend to be highly variable in size and timing, it is very important for the logistics manager to keep low
volumes on hand to avoid large investments in raw materials; as an incentive, the
manager is paid a bonus in every month where raw material turns of at least 12 are
achieved
...
Based on this information, the company’s raw
materials inventory turns for the period were:

(Raw material dollars consumed / Raw material inventory dollars on hand) × 12 =
$138,500 Raw materials consumed
———————————————————————————— × 12 =
($159,900 Beginning inventory + $123,425 Ending inventory) / 2 =
11
...
However, if the
ending inventory value had been used in the measurement instead of the average
value, the calculation would have yielded a turnover rate of 13
...
Because of this difference, the Cod
Fishnet Company’s president should codify the exact nature of the calculation
used to determine whether the bonus is paid
...
How-

ever, the use of high-cost air freight services to bring in inventory at the last
minute can lead a logistics manager to increase freight costs in order to achieve a
high level of raw materials turnover, even though the total cost to the company is
increased by doing so
...


RAW MATERIAL CONTENT
Description: It is useful to determine the proportion of raw material costs in-

cluded in a typical sale so that management can determine if the company is
adding a sufficient amount of value to the product to yield a required level of
profit
...
Also, the measurement can
be tracked on a trend line to see if the proportion of raw material to sales is rising,
which indicates that raw material costs are increasing without a corresponding increase in sales
...
The amount of raw materials can be collected from the bills of material
associated with each product sold, though this only summarizes the standard
amount of raw materials used (which may not reflect actual scrap levels or the
most current raw material costs)
...
The measurement can also be subdivided and tracked for individual products so that the
purchasing staff can see which product margins are suffering from raw material
cost increases
...

This is the responsibility of the logistics manager; however, the president has noticed that this task tends to be delayed by several months, resulting in a higher proportion of raw material costs to sales in the meantime as well as reduced profits
...
3

Sales
Raw materials cost
Raw material content

January

February

March

April

May

$350,000
$210,000
60%

$375,000
$221,250
59%

$320,000
$195,200
61%

$335,000
$234,500
70%

$352,000
$246,400
70%

Consequently, the president asks the accounting staff for a monthly calculation of
raw material content, which will indicate any increases in raw material costs for
which pass-through price increases have not yet occurred
...
3
...
The president heads for the logistics department for a loud discussion with its manager
...
These types of activities are beyond the control of the logistics staff,
although this department is generally considered to be responsible for the calculation’s results
...


FINISHED GOODS INVENTORY TURNS
Description: A company may have an excellent overall inventory turnover rate

but a poor finished goods turnover rate
...
This manufacturing strategy is used by companies that level-load their work forces year-round and by companies that are attempting to increase their loan borrowing bases by pumping up the value of their
inventories by converting them to higher-value finished goods
...

Formula: Divide the amount of finished goods dollars sold during the measure-

ment period by the finished goods dollar amount on hand, and multiply the result

Measurements for the Logistics Department / 203

Table 11
...
5

$3,500,000
$95,000
36
...
5

$3,500,000
$850,000
4
...
In cases where there are highly seasonal sales, it is better to use an average
annualized sales figure than the annualized sales for the month in which the measurement is made
...
Rather than lay off its experienced production team for the
rest of the year, it continues to employ them through the fall and winter seasons,
building finished goods inventories for the next selling season
...
They compile the information shown in Table 11
...

The measurement clearly shows the wide variability in inventory turnover that
is caused by a combination of the company’s seasonal sales and its steady rate of
production through all parts of the year
...
Thus, the measurement can yield different results even when there is no
change in the number of finished goods units on hand
...
First, external auditors will require that an obsolescence reserve be set up against these items, which will lower the inventory value
and create a charge against current earnings
...
Finally, obsolete inventory takes up valuable warehouse space
that could otherwise be put to other uses; monitoring it with the obsolete inventory percentage allows management to eliminate these items to reduce space
requirements
...
The amount used in the numerator is subject
to some interpretation, since there may be an occasional use that will eventually
use up the amount left in stock, despite the fact that it has not been used for some
time
...
The formula is:
Cost of inventory items with no recent usage
——————————————————
Total inventory cost
Example: The logistics manager of the Terrific Truck Supply Company is new to
the job and wants to see if the inventory has an obsolescence problem
...
A query command in the
company’s online inventory reporting system shows that the value of the inventory in the specified range is $248,000
...
9%
...

Cautions: A large amount of obsolete inventory does not reflect well on the lo-

gistics manager, who is responsible for maintaining a high level of inventory
turnover
...
To avoid this problem, the calculation should be given to someone
outside of the logistics department
...
By determining the amount of inventory that is older than
a certain fixed date, the logistics staff can determine which items should be returned to suppliers (see the next measurement) or which items should be sold off
at a reduced price
...
Then determine the dollar value of all items
whose age exceeds this number of days
...
The measurement should be accompanied by a report that lists the
detailed amounts and locations of each inventory item in the numerator so that
the logistics staff can review them in detail
...
Its Christmas candles use a red wax that degrades
after 120 days and must be melted down after that time for reuse as new candles
...
The results of the report show $12,500 of candles that
are at least 60 days old, out of a total candle inventory of $320,000
...
9% ($12,500 divided by
$320,000)
...
This can only be found by comparing the old
inventory list to the production requirements report
...
However, knowledge is needed
of the timing of the sales season for each product on the list
...


PERCENTAGE OF RETURNABLE INVENTORY
Description: Over time, a company will tend to accumulate either more inventory
than it can use or inventory that is no longer used at all
...
Whatever the reason, it is useful to review the inventory occasionally to determine what proportion of it can be returned
to suppliers for cash or credit
...
For these items, use in the
numerator either the listed book value of returnable items or the net amount of cash
that can be realized by returning them (which will usually include a restocking fee
charged by suppliers)
...
The denominator is the
book value of the entire inventory
...
, producer of a teeth-whitening system for

dental patients, is rolling out a new system that does not use several of the components stored in its warehouse
...
The total inventory valuation is $1,475,000
...

The percentage of returnable inventory is:
Dollars of returnable inventory × (1 – restocking fee)
—————————————————————— =
Total dollars of inventory
$230,000 × (1 –
...
5% of Returnable inventory
Cautions: Even though a large proportion of the inventory may initially appear to
be returnable, consider that near-term production needs may entail the repurchase
of some of those items, resulting in additional freight charges to bring them back
to the warehouse
...

This involves the judgment of the logistics staff, perhaps aided by a reorder quantity calculation (see Economic Order Quantity Section), to see if it is cost justifiable to return goods to a supplier that will eventually be needed again
...


INVENTORY ACCURACY
Description: If a company’s inventory records are inaccurate, timely production

of its products becomes a near-impossibility
...
To avoid this
problem, the company must ensure that not only the quantity and location of a raw
material is correct, but also that its units of measure and part number are accurate
...
Thus, inventory accuracy is one of the most
important materials-handling measurements
...
The definition of an accurate test item is one whose actual
quantity, unit of measure, description, and location match those indicated in the
warehouse records
...
The formula is:
Number of accurate test items
—————————————
Total number of items sampled
Example: An internal auditor for the Meridian and Baseline Company, maker of

surveying instruments, is conducting an inventory accuracy review in the company’s warehouse
...
5)
...
The manager is astounded when
the auditor’s measurement reveals an accuracy level of zero, despite perfect quantity accuracy; the manager has completely ignored the record accuracy of part descriptions, locations, and units of measure, and as a result has had multiple
incorrect components of the measurement for some inventory items
...

Cautions: It is extremely important to conduct this measurement using all four

of the criteria noted in the formula derivation
...
5

Aneroid barometer
Battery pack
Connection jack
GPS casing
GPS circuit board
Heavy duty tripod
Plumb line
Sextant frame

Audited
Description

Audited
Location

No
No

No

No
No

Audited
Quantity

Audited Unit
of Measure

No
No
No
No
No
No

208 / Business Ratios and Formulas

description, and location must match the inventory record
...
For example, even if the inventory is available in the correct quantity, if its location code is wrong, then no one
will be able to find it to use it in the production process
...


PERCENTAGE OF CERTIFIED SUPPLIERS
Description: The logistics department certifies a supplier when the supplier’s in-

ternal production systems are considered to be sufficient to ensure that any shipments sent to the company will contain the correct quantities of the correct
components and will have a quality level that meets the company’s minimum
standards
...
In its most advanced form,
this means that certified suppliers can deliver their components directly into the
company’s production line without being reviewed by any company personnel
...
Consequently, logistics department members who wish
to achieve a highly efficient materials flow should track the percentage of certified
suppliers
...
Since certification is a very time-consuming and expensive process, it is likely that not all suppliers will ever go through the certification
process, resulting in a performance measurement that is always less than 100%
...

The formula is:
Number of certified production suppliers
—————————————————
Total number of production suppliers
Example: The American Defense Company produces a complex sonar system for

Navy submarines
...
The company has had
an ongoing problem with damage to these circuits during delivery to the company’s production facility, which is caused both by inadequately robust design of
the product and inadequate use of shipping materials
...
After six months of effort, it certifies 11 of the 20 suppliers, which is a
55% certification level
...

Cautions: Achieving a high level of certification completion is not a one-time

measurement result
...
Consequently, the measurement
should really determine the percentage of suppliers who have been recertified
within the past year (or some other appropriate measurement period)
...
In its most
advanced form, this system allows suppliers to receive listings of scheduled production needs directly from the buying company’s manufacturing planning system, as well as automated purchase orders, while the buying company can receive
immediate feedback from suppliers regarding delivery amounts and dates
...

Formula: Summarize the number of suppliers with EDI linkages to the company

by the total number of suppliers being regularly used by the company
...
Also, the number of suppliers listed in the denominator should not include all incidental suppliers having minimal business with the company (since this can be a formidably
large number), but rather the group of ongoing suppliers who regularly transact
business with it
...
It needs to control the incoming flow of instruments, since its inventory
damage insurance policy will only cover the company for those instruments currently in the restoration process; all other instruments, many of them quite expensive, are at risk while being stored
...
The company has the eight auction houses as clients, all of
whom send it sufficient volume to warrant EDI installations
...

If Musical Heritage is most concerned about limiting its liability under the insurance policy, then the measurement should be targeted at the shipment authorization function, which has achieved an 87
...
If Musical Heritage is also concerned about the shipment confirmation EDI feature, which is useful for scheduling the work flow of its
artisans, then the success rate is only 37
...

Cautions: Achieving an EDI supplier percentage of well below 100% is quite acceptable
...
Consequently, there will be some suppliers whose transaction volumes are so low that installing an EDI system will
never make sense
...
If this approach is used, then a 100% EDI supplier percentage is possible
...
Furthermore, a long-standing ability to always deliver on time gives a
company the ability to reduce the level of safety stock kept on hand to cover potential parts shortages, which represents a clear reduction in working capital requirements
...

Formula: Subtract the requested arrival date from the actual arrival date
...
Also, if an order arrives prior to the requested arrival date, the resulting negative number should be converted to a zero
for measurement purposes; otherwise, it will offset any late deliveries when there
is no benefit to the company of having an early delivery
...
Any of these variations are

Measurements for the Logistics Department / 211

possible, depending upon a company’s perception of the importance of not have
early deliveries
...
Teak fittings are extremely expensive, so the company does not like to have much safety stock on hand
...
Its delivery performance for the
last five deliveries is shown in Table 11
...

By simply summarizing the days variance for all five deliveries, the on-time
parts delivery percentage becomes 1
...
However, this includes the negative
variances caused by two deliveries being received too early
...
Consequently, by resetting these negative variances to zero, the calculation is:
(6 + 4 + 0 + 5 + 0)/5 Deliveries = 3
...
Since this viewpoint
gives a negative connotation to early deliveries, the logistics manager elects not to
reset them to zero for the calculation, but rather to strip away their negative sign,
turning them into positive variances
...
8 Days on-time parts delivery percentage
Thus, the treatment of variances caused by early deliveries can have a considerable impact on the reported amount of a supplier’s on-time parts delivery percentage
...
8 days to a high of 3
...

Cautions: This is an excellent measurement, but it does not address other key as-

pects of supplier performance, such as the quality of the goods delivered (see the

Table 11
...
These additional features can be measured alongside the on-time delivery percentage or melded into an overall rating score for
each supplier
...
Any defect requires
expensive time to document and return and may even interfere with the timely
completion of the production schedule
...
It should be measured both by supplier
and by each component provided by each supplier, in case there are problems with
only some portion of a supplier’s total deliveries to a company
...

Formula: Summarize all rejected components and divide them by the total num-

ber of components received
...
The formula is:
Number of rejected components
————————————————
Total number of components received
Example: The Tango Mural Company, manufacturer of flame-retardant Spanish

tiles, has been having trouble with the receipt of chemicals from a key supplier
...
Consequently, the rejection
of chemicals from its orders has thrown it into an expedited ordering mode in recent months to keep its tile-baking facility operational
...
7 to present to its chemical supplier
...
The purchasing manager decides to take this table into a meeting with the supplier, with
the intention to demand immediate improvement in the rejection rate
...
7

Barrels ordered
Barrels rejected
Purchased component defect rate

Month 1

Month 2

Month 3

512
31
6%

431
30
7%

602
72
12%

Measurements for the Logistics Department / 213
Cautions: If a company’s computerized receiving system allows one to itemize

different types of reasons for a rejected component, it is possible to include more
than one rejection reason when a part is rejected
...
This will result in an apparent number of rejected components that
is higher than the actual amount
...

An increased rejection rate can be caused by a change in the receiving procedures at the company or by a change in the specifications that the company is imposing on its purchased components
...

Also, rejected components may be only one of several key values that a company places on a supplier—other reasons are low pricing and on-time deliveries
...


INCOMING COMPONENTS CORRECT QUANTITY PERCENTAGE
Description: Another key item that the receiving staff is concerned about is the

quantity of items received in comparison to the amount ordered
...
If the quantity is too high, then it may find itself with more inventory than it
can use
...
For these reasons, the
incoming components correct quantity percentage is very commonly used
...
This measurement is commonly applied to each supplier, so that the performance of each one can be measured
...
The basic
formula is:
Quantity of orders with correct parts quantity delivered
———————————————————————
Total quantity of orders delivered
Example: The internal auditing staff of the Wilco Aircraft Radio Company has

brought a potential fraud situation to the notice of its logistics manager
...
This results in full payment

214 / Business Ratios and Formulas

Table 11
...
The auditors’ evidence is listed in the Table 11
...

The table indicates that virtually all orders received from the supplier are considered accurate if the measurement allows for a variation of 5% in the quantity received, while none of the orders would qualify if the tolerance were reduced by
just 1%
...
Further investigation reveals that the
supplier is splitting its profits with the company’s warehouse manager, who is responsible for setting the counting tolerance level
...
This may seem harsh if, for example, an
order of 10,000 units is incorrect by one unit
...
The exact percentage used will vary
based on the need for precision and the cost of the components received, although
5% is generally considered to be the maximum allowable variance
...
Nonetheless, an accounts payable staff person is usually required to reconcile any pricing differences between the two documents, which can
take a great deal of accounting staff time
...
For this
reason, it is useful to determine which suppliers are in the habit of ignoring the
prices at which they are supposed to be billing the company
...
9

Spring Loaded, Inc
...

Foam & Sons
Footpads for Hire
Totals

Total Invoice
Price Paid

Purchase Order
Price Authorized

Variance from
Purchase Order

$217,000
$193,000
$73,000
$69,000
$552,000

$209,000
$184,000
$69,000
$65,500
$527,500

+3
...
8%
+5
...
3%
+4
...
This measurement reveals the most information if it
is organized by individual supplier and accompanied by a detailed listing of exactly which invoices were overbilled
...
Its accounting staff pays for supplier invoices only
after confirming that the related quantities have been received and approved by the
warehouse staff—there is no matching of invoice prices to purchase order prices
...
To prove this point, the manager collects the information in Table
11
...

The table reveals that suppliers are consistently taking advantage of the company by overcharging on their invoices
...

Cautions: An overbilling can be legitimate if there is a valid reason for charging

an extra fee, such as a rush service or delivery charge that is caused by an exceedingly short delivery date, as required by the company, or a change in the
order specifications that occurred after the related purchase order was issued
...


PERCENTAGE OF PURCHASE ORDERS ISSUED BELOW
MINIMUM DOLLAR LEVEL
Description: Issuing purchase orders can be expensive, because the buyer must

investigate pricing, possibly issue bid notifications, review bids, and make a selection before issuing the purchase order
...
To make the purchasing process cost-effective, most organizations prohibit the use of purchase orders for small orders, preferring instead to use corporate purchasing cards or petty cash
...

Formula: Determine a minimum dollar level below which purchase orders should

not be used; this amount will vary by company and will be based on both the volume of orders at different dollar levels and the cost of creating each purchase
order
...
The formula is:
Number of purchase orders issued below minimum dollar level
——————————————————————————
Total number of purchase orders issued
Example: The Windy Electric Utility, which specializes in wind-turbine electric-

ity generation, has a large purchasing staff that is required to issue purchase orders
for virtually all purchases made by the company
...
The logistics manager compiles Table 11
...

The table shows that the company’s purchasing policies are increasingly strict
as the size of an order increases, going from $65 for the smallest order to $1,350
for the largest one
...
Since the average buyer is paid $45,000
per year, the logistics manager believes that more than five positions can be eliminated simply by stopping the purchase order requirement for orders below $100,
and a total of 13 positions can be eliminated if the prohibition is increased to cover
all orders below $500
...
10
Order Size
$500,000+
$2,501–$499,999
$501–$2,500
$101–$500
$100 or less
Total

No
...
g
...
This problem can be avoided by occasionally auditing the orders placed
below the purchase order threshold, looking for appropriate pricing, quantity, and
quality levels
...
Using credit cards reduces the amount of
paperwork required of the purchasing staff, though the control over the types,
quantities, and costs of purchases will decline
...

Formula: Divide the number of credit card purchasing transactions by the total

number of purchasing transactions
...
It may
also be measured for each department or credit card holder, to see where credit
card usage is minimal
...
Acceptance of the new policy has been
spotty
...
The relevant information is in Table 11
...

Predictably, the materials management group, which is supervised by the logistics manager, has a near-perfect 95% credit card usage level
...
11
Number of Credit
Card Transactions
Under $500
Administration
Materials
management
Boat design
Boat testing
Boat sales

Total Number of
Purchasing Transactions
Under $500

Proportion of
Corporate Credit
Card Use

328
2,042

729
2,149

45%
95%

143
298
503

650
1,987
613

22%
15%
82%

218 / Business Ratios and Formulas

engineers in the boat design and testing groups appear to be somewhat less enamored with the concept
...

Cautions: Though 100% usage of purchasing cards for all transactions below a

specific dollar limit is a laudable goal for reducing purchasing labor costs, it is
subject to abuse
...
Furthermore, purchasing cards can be used to make personal acquisitions, or to buy inappropriate items or services
...

However, all these controls should be put in place before a company can determine whether a high proportion of corporate credit card use has actually reduced
its total purchasing costs
...

Since the orders are not authorized, the staff could simply reject them
...
Accordingly, these orders are frequently
set to one side for a few hours or days, while the receiving staff tries to find out
who ordered them
...

Formula: The receiving department should maintain a receiving log, on each line

of which is recorded the receipt of a single product within an order
...
The formula is:
Receipt line items authorized by open purchase orders
———————————————————————
Total receipt line items
Example: The Hoboken Highlanders, makers of Scottish clothing for New Jersey

residents (an admittedly small niche), has eliminated several of its purchasing
controls to increase its level of purchasing efficiency
...
The primary

Measurements for the Logistics Department / 219

Table 11
...
The measurement was less than 20% at the
beginning of the campaign to use this control and has gradually trended upward
since then
...
The trend
line for the past three months is shown in Table 11
...

The assistant sees that the rate of improvement is declining, with only a 3%
month-to-month increase since May
...
Accordingly, the assistant decides to review further the dollar volume of
these transactions before bringing them to the attention of the logistics manager
...
However, it does not include
other types of purchases that never run through the receiving area, such as services, subscriptions, or recurring lease payments
...


FREIGHT AUDIT RECOVERY RATIO
Description: Many auditing firms specialize in comparing the freight bills paid

by a company to the standard rate schedules published by their shippers, to find
overbilling situations
...
Given the amount of funds that can be collected by using
freight auditors, it behooves the logistics manager to track their achieved recovery
ratio to see if they are effective in earning money for the company
...
If more than one auditing firm is being used at the same time, then
this measure should be calculated separately for each one
...
The basic formula is:
Total freight billings refund
————————————
Total freight billings
Example: The Redfern Ski Company ships its super lightweight plastic skis to a

variety of military and rescue organizations throughout the world, which depot
them in remote locations for emergency rescue operations
...
This year, the Robertson Auditing Company is reviewing billings for
Redfern
...
Of the $1,250,000 of freight billings that Robertson reviews, it finds
that 8
...
The calculation of its freight audit
recovery ratio is:
Total freight billings refund – Auditor fee
————————————————— =
Total freight billings
($1,250,000 × 0
...
085 × 0
...
525% Recovery rate
Since Robertson achieved a higher recovery rate, net of their fee, than the previous year’s auditors, Redfern may consider retaining this higher-performing audit
firm for the following year
...
If freight auditors are brought in too
frequently, they may end up reviewing freight invoices that were already reviewed
during the last audit
...


PICKING ACCURACY FOR ASSEMBLED PRODUCTS
Description: When a company ships disassembled products to customers, it is

important that the kits shipped out have exactly the correct number of the right

Measurements for the Logistics Department / 221

parts
...
If the number is too low, then the company faces a significant customer relations problem, as well as added costs to locate and ship
missing parts to customers
...

Formula: Conduct an audit of a sample of completed kits, counting as an error

every kit where the quantity of parts is incorrect as well as for every kit where the
quantity is correct, but the types of parts included are incorrect
...
Then divide the total number of errors by the total
number of product kits sampled
...
The formula is:
Number of quantity errors + Number of part errors
100% – —————————————————————
Total number of product kits sampled
Example: The Swiss Furniture Company ships disassembled kits of Swiss furni-

ture to customers throughout the world
...
To determine the extent
of the problem, the company’s internal audit team pulls 20 completed cabinet kits
from the finished goods storage area and discovers that three units have incorrect
parts and five units have too few parts
...

Based on this information, the picking accuracy for the stereo cabinet is derived
as:
5 Quantity errors + 3 Part errors – 1 Duplicate error
100% – —————————————————————— =
20 Product kits sampled
65% Picking accuracy for assembled products
Cautions: If the company managers think that the key issue is avoiding customer

complaints, then they may be justified in not bothering to count a part overage as
an error
...


AVERAGE TIME TO SHIP
Description: After a product has been manufactured, it may be assumed that it

will be shipped a few moments later
...
In particular,

222 / Business Ratios and Formulas

it is quite common for large custom-made products to require one or more days of
work before a properly configured shipping container can be built for it
...

Formula: For each shipment in a sample group being reviewed, subtract the ac-

tual delivery date from the date when the order was sent to the shipping area
...
The formula is:
Delivery date – Date order was sent to shipping area
Example: The Magellanic Company, maker of custom sea-going rowboats for the

fishing industry, typically spends several days constructing shipping containers for
each of its rowboats
...
The manager derives the information
in Table 11
...

The logistics manager notes that boats longer than 13
...
5 inches being exceeded, requiring considerable extra
time to lengthen
...
5 inches to account for this packaging problem
...
This happens
when the collections staff decides that a customer is not paying for existing invoices in a timely manner and requires the shipping staff to stop shipping products
to the customer until overdue payments are received
...
The problem can be avoided by having the shipping department immediately return these items to the warehouse for storage
...
13
Order Number
307
318
312
310
315

Boat Dimensions (inches)
5 × 12
6 × 15
6
...
5 × 14
6 × 13
...
This means
that a company must ensure that its products arrive at the customer site by a specific date to avoid serious inconvenience to the customer (which may even involve
penalties or the outright rejection of the order if the arrival date is missed)
...

Formula: For a selected sample of deliveries, subtract the actual order delivery

date from the required delivery date, resulting in an average variance for the
group
...
The formula is:
Required delivery date – Actual delivery date
Example: The Tic-Tac Dough Company’s marketing staff wants to reposition its

premier bagel product lines as the freshest in the marketplace by ensuring that only
bagels cooked within the past four hours are delivered to its numerous supermarket outlets
...
On the previous day, it achieved the delivery
results shown in Table 11
...

Of the five deliveries made, only batch number 146 arrived later than the designated time
...

Cautions: This is an excellent measurement
...
Consequently, the measurement can be modified to count a delivery
as being on-time only if it arrives within a certain number of days (or hours) of the
customer-specified time
...
14
Batch Number
143
144
145
146
147

Time Left Bakery

Time Arrived Store

Elapsed Time

3:50 AM
3:55 AM
4:00 AM
4:05 AM
4:10 AM

7:00 AM
6:42 AM
7:15 AM
8:11 AM
8:05 AM

3:10
2:47
3:15
4:06
3:55

224 / Business Ratios and Formulas

rush delivery services, which are quite expensive
...


PERCENTAGE OF PRODUCTS DAMAGED IN TRANSIT
Description: Some types of products are fragile by nature and require special

packaging to ensure that they arrive at the customer in good order
...
For these reasons, tracking the percentage of products damaged in transit is an important measurement
...
The measure can be separated by freight carrier, since
some have more difficulty in moving fragile items than others
...
The formula is:
Damage-related customer complaints
———————————————
Number of orders shipped
Example: The Crystal Ball Corporation, maker of various crystal gifts for chil-

dren, has had a long-term problem with product breakage during transit
...
It is now focusing its
efforts on the delivery companies that transport its shipments
...
15
...
If the International Air Freight Company does domestic deliveries, then its 1% damage rate should qualify it to take over much of
DunRight’s business
...
15
Freight Company
ABC Freight
Danville Shippers
DunRight Shippers
International Air Freight

Number of
Complaints

Total Orders
Shipped

11
42
152
8

549
1,042
1,693
841

Percentage
Damaged in Transit
2%
4%
9%
1%

Measurements for the Logistics Department / 225
Cautions: There can be a time delay between the point when a customer com-

plaint is received and the date when the related product was shipped, so that the
time period covering the numerator in the calculation is somewhat earlier than the
time period covering the denominator
...
The
problem can be mitigated by using larger time periods for the measurement, such
as quarterly instead of monthly
...
Each channel should be measured to see where the bulk of company
business is being generated
...
This measurement is listed in the logistics
chapter instead of the sales chapter because the type of distribution channel has a
profound impact on the cost structure of the logistics department’s shipping costs
...
Also, customer support is sometimes handled by distributors, whereas
direct sales require a company to handle this function itself
...
This measure can be used for any other sales channel, and
can also be separated into sales by different product lines or geographic regions
...
It

began by selling through golf course pro shops in the Virginia area and has since
used a variety of sales channels to increase its sales throughout North America
...
The president collects the information shown in Table
11
...

By splitting sales into sales channels and then taking the extra step of determining net margins on each channel, the president can see that the catalog sales
channel should be eliminated, given its net losses
...


226 / Business Ratios and Formulas

Table 11
...
This is usually difficult to achieve and
requires some manual revision of the numbers stored in the general ledger
...
If only the
gross margin associated with the various sales channels is incorporated into the
calculation, then the reverse conclusion may be reached, since this measure will
only show the reduced prices that are typically granted to distributors
...

Instead, most of the information from which they are derived is obtained from
other sources, such as tracking systems for units of production, machinery utilization time, and scrap tracking
...

The measurements described in this chapter fall into several categories: the utilization of key production constraints, also known as bottleneck operations; overall productivity and effectiveness; asset usage; and overhead expense utilization
...
If the efficiency of some other operations were to be enhanced, the bottleneck would still
exist, and so overall manufacturing output would not improve
...
If several different products are being continually run through the bottleneck operation, all requiring different processing
times, then the measure should be separately calculated for each product so that productivity can be more precisely determined
...
The formula is:

Number of units produced per hour
———————————————
Number of hours worked
Example: The Aboriginal Paintwork Company runs all of its hand-thrown ce-

ramic products through a kiln, which is the bottleneck in its single-shift operation
...
The
manager collects information over a three-month period that includes several company holidays that is shown in Table 12
...

The table shows that the increased number of work days occurring during the
three-month period has created the appearance of greater efficiency at the kiln,
even though the actual level of productivity has gradually declined on a per-hour
basis throughout the period
...
Consequently, this measure
should be used in conjunction with a review of the total gross margin being generated by the bottleneck operation
...
1

Number of units produced
Number of work days
Number of available hours
Constraint productivity

May

June

July

6,400
20
160
40/hr

6,552
21
168
39/hr

6,688
22
176
38/hr

Measurements for the Production Department / 229

CONSTRAINT REWORK PERCENTAGE
Description: A bottleneck operation limits the total amount of production work

that can be completed by a manufacturing facility, so the volume of work passing
through it must be maximized
...
Consequently, the production manager should closely
track the amount of rework time at the bottleneck operation
...
For example, if a constraint operation
can be used 24 hours a day, then this should be used in the denominator
...
A
number of sanding problems have been recognized downstream from this operation, necessitating rework that must pass through the belt sander a second time
...
The belt-sanding operation runs 24 hours a day, 365 days a year
...
If sanding
flaws can be corrected by hand, then this option should be pursued instead of using
any capacity in the bottleneck for the same task
...
For example, if three hours of rework were required for manual sanding and
two hours for belt sanding in a 24-hour day, then only the two hours used for belt
sanding should be divided by the 24 hours of available capacity to arrive at a constraint rework percentage of 2/ 24, or 8
...

Cautions: Rework that can be shifted to other machines than the bottleneck op-

eration should be excluded from the calculation, but only if it is in fact shifted elsewhere
...


230 / Business Ratios and Formulas

CONSTRAINT SCHEDULE ATTAINMENT
Description: A bottleneck operation is being used most efficiently when the exact
amount of production scheduled to pass through it actually does so
...
This measurement is used
to determine a production manager’s efficiency in producing in accordance with
the production plan
...
This measure can be used for all operations within a manufacturing facility, but the key measurement is on the constraint operation, since shortfalls here will have the largest impact on overall output
...
Also, the number of hours of work itemized
in the production schedule is based on the standard estimate of hours required; if
the work is completed with a variance from the standard, then this variance should
be included in the numerator in the formula
...
During the current month, its 10 tire lamination machines are scheduled to
produce tires for a total of 7,200 hours, which constitutes full production for 24
hours a day for all of the machines
...
In addition, because of engineering improvements, they saved 100 hours from the standard production time estimated for completion of the job, due to better monitoring of the
tire lamination times
...
To determine the constraint schedule attainment
ratio, the production manager uses the following calculation:

Part hours produced + Rework hours – Reduction in actual hours
from standard
——————————————————————————— =
Part hours scheduled
6,980 Production hours+ 250 Rework hours – 100 Hours variance from
standard hours
—————————————————————————————— =
7,200 Parts hours scheduled
7,130
——— =
7,200
99% Schedule attainment

Measurements for the Production Department / 231
Cautions: The number of part hours produced may not encompass the parts itemized in the production schedule, so the underlying data should be cross-checked
against the production schedule from time to time to ensure that the exact part
types and quantities dictated by the schedule are being followed
...
For example, if a production job is
scheduled to be run and completed on the first day of the month, but is actually run
on the last day, then a measurement encompassing the entire month will still indicate that the production schedule was successfully met, even though the customer
had to wait much longer than promised to receive the product
...


CONSTRAINT UTILIZATION
Description: If there is no production schedule in place, then there is no need for

the preceding constraint schedule attainment measure
...
This measure does not tell one if the highest-profit goods are
being prioritized in the constraint operation, as would be the case if a production
schedule were used, so it is a less precise measure
...
The formula is:
Actual hours used in constraint operation
—————————————————
Total constraint hours available
Example: The Medic First Response Corporation assembles first aid kits in an assembly line
...

This machine runs at approximately one third of the speed of the assembly line, so
it must operate on all three shifts in order to keep up with the output from the assembly line
...
During the preceding five-day
work week, the machine was in operation for 110
...
To determine the constraint utilization, the manager runs the following calculation:

Actual hours used in constraint operation
————————————————— =
Total constraint hours available
110
...

Since this may exclude highly profitable production from being placed first in
the work queue, the measure does not relate well to the amount of profits being
generated
...


DEGREE OF UNBALANCE
Description: The degree of unbalance refers to the amount of productive capac-

ity in a production cell that cannot be utilized because of the presence of a production bottleneck
...
By doing
so, the productive flow within a manufacturing cell becomes much smoother and
can achieve a higher rate of output
...
A variation on this approach is to determine the average capacity of all other machines
in the work cell and use this amount in the denominator
...
The formula is:
Maximum Capacity of the Work Cell Bottleneck Operation
—————————————————————————————
Maximum Capacity of the Next Most Restrictive Work Cell Operation
Example: The production manager of the McGraw Rifle Company is concerned

about the size of a prospective order from the Army for a new military submachine
gun called the P-16
...
The three lathes in this work
center are the capacity constraint, followed by the metal shears, and then the
stamping machines
...
The manager accumulates capacity information which is shown in
Table 12
...

Divide the weekly capacity of the lathes, at 875 units, by the weekly capacity
of the shears to arrive at a degree of imbalance measurement of 78%
...


Measurements for the Production Department / 233

Table 12
...
For example, if the industrial engineering staff finds that the degree
of unbalance is an excessive 50% by using this measurement, it may find, after
doubling the capacity of the bottleneck, that the degree of unbalance has only improved to 60%
...

The degree of unbalance may not be a very useful number for work cells that
rarely reach their maximum levels of production capacity
...


THROUGHPUT EFFECTIVENESS
Description: This measure reveals the trade-off between maximizing throughput

and other operating expenses
...
Comparing throughput to these other operating expenses can help to determine the point at which the ratio can no longer be
maximized which implies that additional operating expenses should not be incurred from that point
...
If the measure results in a ratio of anything greater than 1:1,
then a prospective increase in operating costs that can be tied to an increase in
gross margins should be accepted
...
In the strictest sense, variable
production expenses can be construed as only direct materials, with all other production expenses falling into the category of operating production expenses
...
The formula is:

234 / Business Ratios and Formulas

Gross revenue – Variable expenses
———————————————
Operating production expenses
Example: A production manager is interested in adding a quality control person

to a constraint operation in order to manually review 100% of the materials coming into the machine
...
On average, these clogs occur 1
...
The amount of revenue that could have been produced while
these clogs are cleared averages $800 per hour
...
78
...
Using the throughput effectiveness measurement, is it cost-effective to incrementally make this addition to
the production operation? The production manager uses the following formula:
Gross revenue – Variable expenses
——————————————— =
Operating production expenses
(1
...
5 Clogs × 360 Days × ($800 Revenue ×
0
...
Therefore, the production manager should hire the quality control person
...


BREAK-EVEN PLANT CAPACITY
Description: The break-even plant capacity measurement reveals the point at

which a facility’s output exactly equals the expense associated with running it
...

Formula: Multiply the current plant utilization level by the total amount of fixed

costs currently incurred by the plant
...
There may be varying points of view regarding
which costs are listed in the denominator as variable, and which are listed in the
numerator as fixed—no matter how the issue is settled, be sure to include all costs
somewhere in the formula, with no exclusions (except for extraordinary costs)
...

The formula is:
Current utilization level × Total fixed costs
——————————————————
Sales – Variable expenses
Example: The Archly Investment Company is considering the purchase of the

Sinclair Aircraft Company
...
The director of Archly is
keenly interested in the break-even plant capacity to see if there is much upside
potential, or if the break-even point is so high that the facility would be unable to
turn a significant profit even if the market increased considerably
...
The calculation is:
Current utilization level × Total fixed costs
—————————————————— =
Sales – Variable expenses
(40% Current capacity level) × ($25,425,000 Fixed costs)
———————————————————————— =
($46,500,000 Sales) – ($30,925,000 Variable expenses)
$10,170,000
————— =
$15,575,000
65% Plant break-even capacity
Given the 65% plant break-even capacity level, there appears to be room for
additional profits if sales increase
...
The facility uses 40%
of its capacity to generate $46
...
Also, the existing gross margin is 33%
(based on sales of $46
...
925 million, divided by
sales)
...
3
...
3
Income Statement
Revenue

$116,250,000

Gross margin percentage

Gross margin dollars
Fixed expenses
Profits

33%

$38,362,500
$25,425,000
$12,937,500

Calculation
$46,500,000 existing sales/
40% current capacity utilization
($46,500,000 existing sales –
$30,925,000 existing variable
expenses)/existing sales
Calculated
Existing level of fixed expenses
Gross margin—fixed expenses

Although a large amount of profits appears to be possible if sales increase, the
director understands that production costs tend to rise exponentially as production
capacity approaches 100% utilization, because of excessive machine usage and
consequent equipment breakdowns, overtime costs, and logistics difficulties
...
It is important to ensure that all plant costs
are included in either the variable cost or fixed cost elements of the equation, since
the breakeven point will otherwise be lower than the real level required to cover
all costs
...


MANUFACTURING EFFECTIVENESS
Description: Even if the utilization level at a constraint operation is quite high, this
does not necessarily mean that the hours being used at the operation are being effectively translated into more shipments to customers
...
If
a significant proportion of the production hours used at a constraint operation are
used in these activities, then the number of throughput hours used to create products
that are actually shipped to customers will be reduced, resulting in lower profits
...

Formula: Divide the total throughput hours shipped in the reporting period by the
total number of constraint hours consumed
...
The operation runs during all three shifts, seven days a week, so there is no way to increase its total output without purchasing an additional blow molding machine
...
The manager compiles the following information:
Total hours of constraint usage/week
Hours used for production run setups
Hours used on shells that are scrapped

168 Hours
38 Hours
12 Hours

Based on this information, the manager finds that manufacturing effectiveness
of the operation is only 70%, which is derived as:
168 Total throughput hours –38 Setup hours –12 Scrap hours
—————————————————————————— =
168 Total constraint hours consumed
118 Throughput hours shipped
——————————————— =
168 Constraint hours consumed
70% Manufacturing effectiveness
To increase the manufacturing effectiveness of the blow-molding operation, the
director hires the most experienced setup engineers available, hoping to reduce the
amount of setup hours required to switch over to new production jobs
...
If so, the measurement of constraint hours consumed will fall into one reporting period, while the measurement of throughput
hours shipped may fall into another, making it difficult to compile the information
needed for the measurement
...


PRODUCTIVITY INDEX
Description: The productivity index can be used to measure a variety of activi-

ties within a production operation that lead to changes in the volume of units
manufactured
...
Similarly, if more direct
labor dollars are spent in an assembly line, there should be a corresponding increase in the volume of units produced
...

Formula: Divide the total change in output quantities by the total change in input

quantities
...
For example, the change in scrapped units
can be compared to a change in additional hours spent on training machine operators
...
The formula is:
Total change in output quantities
——————————————
Total change in input quantities
Example: A punch press operation is producing an excessive quantity of scrap,
due to poorly positioning parts on the presses
...
As a result of spending 312 hours of both operator and
trainer time, the scrap rate drops from 15% to 8%
...
” Accordingly, the manager converts the inputs and outputs into dollars
...
50,
which is a total input of $6,084
...
25 and
by the monthly unit production volume of 10,000 units, which results in an incremental change in output of $2,975
...
When the comparison is extended over several periods, the ongoing improvement in scrap levels will yield
a very high productivity index
...
For example,
if five separate changes are made to the production process, it is impossible to determine what proportion of the resulting change in production outputs was caused
by each one
...

It is also possible that there is no direct causal relationship between an input
and an output, in which case the comparison should not be made at all
...
In most
situations, direct labor composes only a small proportion of the value added, so
there is only a poor causal relationship between the amount of unit output and the
number of direct labor hours worked
...

Formula: Add together the total number of units completed during the production
period and the total number of unit equivalents, less the total number of unit equivalents recorded at the end of the preceding reporting period
...
A unit equivalent
is defined as that completed proportion of an incomplete unit of production on
which work has been finished
...
40 unit equivalents
...
20 unit equivalents
...
60 unit equivalents
...
At the end of the preceding period, Job A
was 30% complete, Job B was 49% complete, and Job C was 83% complete
...
62 units of production
(30% + 49% + 83%)
...
Job A was 85% complete, Job C was 98% complete, and
Job D was 32% complete
...
The calculation of unit output per direct labor
hour is:

Total units completed + Total unit equivalents –
Total carryforward unit equivalents
———————————————————— =
Total number of direct labor hours
1 Unit completed + (
...
98 +
...
62 Carryforward units)
——————————————————————— =
2,418 Direct labor hours
1 Unit completed + 2
...
62 Carryforward units
—————————————————— =
2,418 Direct labor hours

240 / Business Ratios and Formulas

1
...
00063 Units per direct labor hour
Cautions: When compiling data for this measurement, be careful about the
method used to derive equivalent units
...
A good approach is to determine the number of actual hours already spent on a product, per the job tracking system, and compare this to the standard number of hours recorded on the
labor routing to determine the percentage of completion
...
However, verify the accuracy of the standard hours listed in the labor routings to ensure their accuracy
...


AVERAGE EQUIPMENT SETUP TIME
Description: This measurement is useful in situations where equipment is being

run at maximum capacity, so it is critical to have the smallest possible amount of
equipment down time between production runs
...

Formula: Subtract the stop time for the preceding production run from the start

time for the next production run
...
However, it assumes that there
are jobs continually following each other that require continual shifts to new jobs,
with no downtime in between
...
If this
is the case, the start and stop times can be manually tracked, though this tends to
be inaccurate (especially when the person doing the time tracking is also responsible for the setup)
...
Because
a considerable degree of retooling is required to switch machinery over to a different transmission, the equipment setup time can take over a week to complete
...
They use videotaped practice setups to determine what
steps can be eliminated or shortened, finding that half of the setup time can be
eliminated simply through the prepositioning of parts, using different types of
lockdown bolts, and requiring the setup staffs to use a formal setup checklist
...
During the
four days of saved setup time, the factory is able to produce an additional 582
transmissions, each with a gross profit of $225 dollars
...

Cautions: When this measure is being reported manually by equipment setup

teams, they will have an incentive to report a short setup time if they have any sort
of performance incentive to keep setups short
...
A much better approach is to use an automated machine usage tracking system that automatically
sends information to a central location; however, these systems are expensive
...

When equipment fails outside of this schedule, the production planning staff must
quickly reorganize the production schedule around the capacity of whatever
equipment is no longer available for use
...
The unscheduled machine downtime percentage is most useful for
tracking a company’s ability to minimize this problem
...
This calculation can be summarized for all machines or
individually for each one
...
The formula is:

Total minutes of unscheduled downtime
—————————————————
Total minutes of machine time
A variation on the ratio is to divide the total minutes of unscheduled downtime
by the total minutes of scheduled downtime; this measurement gives a better idea
of the maintenance staff’s ability to spot upcoming equipment problems and properly schedule them for repair in concert with the production schedule, rather than
spending all of its time repairing equipment on a rush basis
...
The formula is:

242 / Business Ratios and Formulas

Table 12
...
1

Press No
...
3

29
720
4%

14
720
2%

101
720
14%

Total minutes of unscheduled downtime
—————————————————
Total minutes of scheduled downtime
Example: The Ajax Machining Company produces a number of lawn shear mod-

els, all of which must be completed by April in order to be in stores for the crucial
summer selling season
...
The production manager wishes to avoid this problem in the
upcoming production season and chooses to use the unscheduled machine downtime percentage to track the progress in fixing the problem
...
4 for the last month for a set of presses that have had
persistent maintenance problems
...
Further investigation reveals that it has a continual history of
maintenance problems and is also the oldest press owned by the company
...

Cautions: Calculation of this measurement requires access to machine timetracking equipment that is directly linked to the equipment to monitor ongoing
processing; this equipment is quite expensive
...


ACCEPTABLE PRODUCT COMPLETION PERCENTAGE
Description: In an ideal situation, 100% of all products produced are acceptable

to customers and can be shipped to them
...
If the number is significant, then a company is wasting a large amount of direct materials and processing
time
...

Formula: Subtract the number of products in a production run by the number of

rejected products, and divide the result by the number of products in a production

Measurements for the Production Department / 243

run
...
The formula is:
(Number of products in production run) – (Number of rejected products)
——————————————————————————————
Number of products in production run
Example: The Ultra Hose Clamp Company manufactures several sizes of hose

clamp
...
The production manager wishes to
determine the acceptable production completion percentage for all hose clamps
manufactured in June, not only in total but also for each manufacturing step
...
5
...
For example, the initial production quantity was 42,500 units,
but 429 units were rejected during the initial slot-punching process, thereby leaving only 42,071 units to be run through the band-slicing process
...
Based on the information in the table, it appears that
management attention should focus on the clamp insertion process, where the
bulk of all rejections are arising
...
At its most strictly defined level, it can be interpreted as only those
products that have gone through the entire production process and then been rejected
...
In addition, unacceptable products may escape detection by the quality control system and be shipped to customers, who then return
them for refunds or warranty claims
...


Table 12
...
0%

99
...
6%

94
...
Measuring its turnover can give one a reasonable idea of the efficiency of the production operation in maintaining high
production levels with minimal inventory stockpiles between the production operations
...
If a large ramp-up in sales (and therefore the cost of
goods sold) is budgeted for later in the year, it may be better to derive the annual
cost of goods sold figure used in the denominator by using the last twelve months
of cost of goods sold; by doing so, possibly unlikely budget data can be replaced
with actual data
...
It should result in much better control over the
production process, and reduce the amount of work-in-process inventory needed
...
He collects the
information in Table 12
...

The turnover trend line in the table confirms that the MRP II system appears to
be gradually increasing the work-in-process turnover rate
...

Cautions: The exact amount of work-in-process currently in use can be an ex-

tremely difficult number to determine
...
A

Table 12
...
8

190,000
$1,450,000
7
...
0

170,000
$1,450,000
8
...

Also, this measure is not useful in a just-in-time (JIT) production environment,
since there should theoretically be so little work-in-process inventory that the
measure would be meaningless
...


SCRAP PERCENTAGE
Description: The amount of scrap generated by a production operation is of great

concern to the production manager, for it can be indicative of a number of problems—poor training of the direct labor work force, improper machine setup, materials handling problems, or even the ordering of substandard raw materials
...
For these
reasons, the scrap percentage is one of the most closely watched performance
measurements in the factory
...
If this is the case, the best approach is to
subtract the standard cost of goods sold from the actual cost of goods sold, and divide the result by the standard cost of goods sold
...
The
formula is:
Actual cost of goods sold – Standard cost of goods sold
———————————————————————
Standard cost of goods sold
A variation on this formula is to track only the scrap generated by the bottleneck production operation
...

Example: The production manager of the Pelican Lawn Products Company wants

to calculate the scrap percentage of his manufacturing facility, and therefore accumulates the following information:

246 / Business Ratios and Formulas

Actual direct labor
Actual direct materials
Actual overhead
Standard direct labor
Standard direct materials
Standard overhead
Standard scrap

$145,000
580,000
870,000
142,000
542,000
745,000
12,000

The production manager wants to exclude overhead costs from the calculation
in order to concentrate on just those costs most directly related to scrap
...
The resulting calculation is:
(Actual direct labor + Actual direct material) – (Standard direct labor +
Standard direct materials – Standard scrap)
————————————————————————————— =
(Standard direct labor + Standard direct materials – Standard scrap)
($145,000 + $580,000) – ($142,000 + $542,000 – $12,000)
————————————————————————— =
($142,000 + $542,000 – $12,000)
$745,000 – $672,000
————————— =
$672,000
10
...
One problem is that there may be a standard scrap value already included in the bills of material that comprise the standard cost of goods sold, so these values must be
extracted from the standard in order to determine the actual amount of scrap
...
These variances must be calculated and removed from the actual cost of goods sold before
the amount of scrap can be determined
...
To avoid this problem, include in the cost of goods sold
only the direct labor and direct materials costs associated with production, removing all overhead costs
...


Measurements for the Production Department / 247

WARRANTY CLAIMS PERCENTAGE
Description: Warranty claims can be caused by a poor product design, the use of

raw materials having inadequate specifications, or improper production
...
When warranty claims are high, this becomes a valuable tool for
judging the quality of a company’s products
...
Since there may be a significant time lag between the date
when a warranty claim is received and the date of production, it is best to accumulate this information over a number of months on a rolling basis, so that there
is a reasonable basis of comparison between the two numbers
...
The
company manufactured this product through the six months leading up to the
summer selling season, after which it stopped production and does not plan to
begin again until the end of the year
...
The total number of units produced
was 183,000, and the number of claims filed thus far is 1,897
...
The production manager should consider marking the product differently in each successive year so that returned
products can be easily associated with a specific production year
...
Also, when a company

248 / Business Ratios and Formulas

sells its products through intermediaries, such as large retail chains or distributors,
these entities may sometimes use the warranty claims process as an excuse for returning unsold products that have no defects at all
...


MAINTENANCE EXPENSE TO FIXED ASSETS RATIO
Description: The ability of the production function to operate at its maximum

levels of productivity are strongly influenced by the amount of investment that a
company is willing to make in the ongoing repair and maintenance of its fixed assets, most of which tend to be concentrated in the production area
...

Formula: Divide the total amount of maintenance and repair expense by the total

gross amount of fixed assets
...
The formula is:
Maintenance and repair expense
——————————————
Total gross fixed assets
Example: A production manager wishes to determine that portion of the mainte-

nance expense to fixed assets ratio that pertains just to his department
...
Of the assets, all the
machinery assets are assumed to belong in the production department
...
If there is no information available about
fixed asset replacement, then an alternative approach is to split the amount of
maintenance and repair expenses into its labor and materials components
...

Another issue is that some repairs are of a singular nature and will not recur for
some time
...
If there are sudden spikes in the trend line of maintenance and expense repairs, they may be indicators of these unusual items, which can then be excluded
from the ratio
...
In established markets, there is usually a
consistent relationship between the amount of indirect expenses incurred and the
volume of production
...

Formula: Divide the total of all indirect production expenses in period two by the
number of units produced in the same period
...
By comparing the results for two consecutive periods, it can be easily seen if the relationship between
indirect expenses and units of production is rising or falling; any number greater
than one represents an increase in per-unit indirect costs over the prior period
...
7

Total indirect expenses
Total units produced
Ratio of indirect expenses to units produced
Indirect expense ratio

September

October

November

$157,000
2,250,000
$
...
073/unit
1
...
074/unit
1
...
The
relevant production and unit information for the last three months is shown in
Table 12
...

The indirect expense ratio reveals at least part of the problem; the former production manager had not reduced indirect expenses in proportion to the drop in
production units manufactured, resulting in a gradual increase in the amount of indirect expenses to units produced
...
For example, a manufacturer of Christmas
ornaments may experience extremely high production volumes in the months preceding Christmas, but nothing directly thereafter
...


REORDER POINT
Description: The reorder point can be used as a valid measurement by the pro-

duction or logistics department
...

Formula: Multiply the average usage per time period by the ordering lead time,

and then add a predetermined amount for safety stock
...
8
Month
January
February
March
April
May
June
Average usage

Kick Plate Usage
1,258
542
1,602
770
894
1,195
1,044

Example: The Open Sesame Door Company purchases large quantities of door

kick plates from a brass supplier
...
The production manager needs a reorder
point that ensures that the company never runs out of kick plates again
...
8
...
To avoid this problem, the manager must add safety stock to the average usage figure
...
In this case, the maximum
usage was in March, when 1,602 kick plates were needed
...
Thus far, it appears that the safety stock should be 1,602 units, which
is also the maximum amount of usage that can be expected during the year
...
The average lead time for purchases of kick plates is five business days, or
one-quarter of a month
...
Accordingly, the
manager modifies the calculation for the short lead time in the following manner:
(Average usage per time period × Lead time) + Safety stock
———————————————————————————— =
(1,044 Units of average usage × 1⁄4 Month lead time) + (558 Units of
safety stock × 1⁄4 Month lead time)
(1,044 × 1⁄4) + (558 × 1⁄4) = (261 + 140) =
401 Unit reorder point
Cautions: This measurement is based solely on the concept of purchasing with

historical usage information
...
However, it will jeopardize the production

252 / Business Ratios and Formulas

process if there is a sudden surge in the volume of required production, since this
will overwhelm the amount of inventory left on hand as safety stock and will then
bring production to a halt for lack of materials
...

Another issue is that the reorder point is based on the assumption of continuing usage of a part but does not account for the termination of a part
...
Unless someone manually eliminates the reorder point calculation
for this part, the system will recommend placing an order that will keep the company fully stocked with the part, even though it is no longer needed
...

Yet another problem is that the lead time may vary based on the supplier used
as well as the time of year (since suppliers may suffer from surges in orders at
high-volume times of the year)
...


ON-TIME DELIVERY RATIO
Description: Though on-time delivery can be considered a logistics function, a

product cannot be delivered until the production department has manufactured it
...
This is a key determinant of customer satisfaction and should be used by any
company that ships products to customers
...

Formula: Divide the number of orders shipped on or before the customers’ re-

quired due dates by the total number of orders shipped
...
A more restrictive variation is to use as a
customer due date the date of delivery that will ensure the customer receives the
product by its mandated due date
...

However, this measure can be strongly skewed by the presence of a few large orders, so that a company appears to have an excellent on-time delivery ratio, despite
shipping many smaller orders late
...

This manufacturer of aluminum and steel dive tanks ships tanks to dive shops all
over the world, which can involve long shipping times
...
In May, the production department recorded the performance shown in Table 12
...

According to the table, the production department missed a delivery date for a
shipment to Undersea Adventures in Palau
...
Consequently, five of the six orders were shipped on time, which is an on-time delivery percentage of 83%
...

Cautions: This measure is commonly used as a key measure of performance, and

so can be a determinant of bonuses paid to the production and logistics staffs
...
This can be
done by accessing customer order records and altering the due date
...

Also, if the measurement is set up to record a shipment date that is a few days before the actual customer due date (in order to account for transit time), the production staff may take a liberal view of the amount of transit time required
...
To avoid this problem, there should
be a standard policy dictating the number of assumed transit days for different distances at which customers are located from the production facility, and which are
used to determine the required shipment date
...

Table 12
...
Since it is so crucial to
overall operations and financial viability, its performance should be tracked with
several types of ratios and formulas
...
The measurements presented in this chapter are
Market Share
Customer Turnover
Browse to Buy Conversion Ratio
Recency
Direct Mail Effectiveness Ratio
Inbound Telemarketing Retention
Ratio
Quote to Close Ratio

Sales per Salesperson
Sales Productivity
Sales Effectiveness
Sales Trend Percentage by Product
Line
Product Demand Elasticity
Days of Backlog

MARKET SHARE
Description: Company managers may think that the company’s sales volume is

rising, and yet it may not be keeping pace with the overall sales increases within the
market
...
Consequently, a periodic measurement of market share yields an approximate
view of a company’s sales performance in relation to the market as a whole
...
1

Company sales
Market size
Market share

Quarter 1

Quarter 2

Quarter 3

Quarter 4

$35,000,000
$292,000,000
12%

$40,000,000
$364,000,000
11%

$45,000,000
$450,000,000
10%

$50,000,000
$556,000,000
9%

Formula: Summarize the dollar volume of all unit sales within a market, and di-

vide it by the total dollar volume of industry shipments
...
The formula is:
Dollar volume of company shipments
————————————————
Dollar volume of industry shipments
Example: The Speedy Semiconductor Company has been experiencing exceed-

ingly rapid sales growth for the past few quarters
...
The market share data from the
Semiconductor Industry Trade Organization and Speedy’s sales data for the same
period are shown in Table 13
...

The market share ratio shown at the bottom of the table should concern the
president of Speedy, for the company’s sales growth is not matching the overall
size of the market
...

Cautions: A company can artificially increase its market share by stuffing sales

into its distribution pipeline by offering special pricing arrangements to its distributors; this will artificially increase its market share until the next reporting period, when sales are likely to plunge below their earlier levels (since the
distributors are still selling off their extra stocks from the last period), appearing
to indicate a sudden reduction in market share
...

Another problem is that the dollar volume of industry shipments can be quite
hard to compile and may be inaccurate even when this chore is completed
...
A very low turnover rate is important in
situations where the cost of acquiring new customers is high
...
In some cases, this may be anyone who has not placed an order
within the past month and in other cases within the past year
...
With this in mind, the formula
is to subtract from the total customer list those that have been invoiced (or sold to
on a cash basis) within the appropriate time period and then divide the remainder
by the total number of customers on the customer list:
Total number of customers – Invoiced customers
—————————————————————
Total number of customers
Example: The customer service department of the Indonesian Linens Company is

being inundated with requests from the president to reduce the company’s high
rate of customer turnover, which is currently 30% per year
...
Mr
...

The customer service manager gratefully shifts the department’s focus to these
key customers
...
Noteworthy calculates customer turnover
both in total and for this smaller group of key customers, using the information in
Table 13
...

The table shows that, although overall customer turnover has not changed, the
increased focus on high-profit customers has resulted in greatly reduced turnover
in this key area
...
Another
variation on the ratio is to determine the top customers who provide the company
with the bulk of its profits and only measure the turnover rate among that group
...


Table 13
...
However, this
is a simple and effective calculation for any situation where the store is on-line,
since the exact number of browsing customers can be compiled
...

Formula: Divide the number of buying customers by the number of browsing

customers
...
This type of “slice and
dice” measurement may yield a greater degree of accuracy in determining which
parts of an on-line store are most effective in attracting customer orders
...

The company’s lead buyer, Mr
...
The developer is willing to modify the Web
pages depicting products, but not the home page
...
The development contract states that the developer will be paid 10% of the
sales from the increased proportion of buyers for six months following installation
of the new Web pages
...
3 reveals the before-and-after statistics for the
site
...
3

Number of buying customers
Number of browsing customers
Browse to buy conversion ratio
Average sale per customer

Before Changes

After Changes

10,400
130,000
8%
$12

17,225
157,000
11%
$15

Measurements for the Sales and Marketing Department / 259

The developer’s efforts have resulted in an improvement in the ratio of 3%
...
Smythe multiplies the 3%
difference by the number of browsing customers after the changes are implemented, which is:
3% × 157,000 Browsing customers = 4,710 Additional buying customers
He then multiplies the increase in buying customers by the average sale per
customer of $148, to find the amount payable to the developer
...
For example, it can be summarized from
the number of potential customers who access the home page of the site, from the
number who access specific product pages, or those who have placed an order but
back out just prior to paying
...


RECENCY
Description: Recency refers to the time period between visits by a customer to a

company’s retail location
...
However, online stores can easily determine when customers have accessed the site, and so have reasonable grounds for calculating this measure
...
By issuing
advertisements, special deal notices, and so on, and then noting any changes in the
recency measure, a company can see if its marketing efforts are changing the purchasing behavior of its customers
...
This number can be summarized and averaged for all customers,
or for select subgroups of customers
...

Example: The Christmas Express Company’s marketing manager wants to cal-

culate the recency of the customers accessing its online store
...
4
...
4
Last Visit Date
August 13
August 12
August 10
August 17
August 20
August 9
August 30
August 29
August 27
August 23

Prior Visit Date

Recency

August 2
August 4
August 1
August 16
August 5
August 3
August 10
August 11
August 13
August 7

11 Days
8 Days
9 Days
1 Day
15 Days
6 Days
20 Days
18 Days
14 Days
16 Days

The average recency for the information in the far right column of the table is
11
...

Cautions: It may not be that easy to trace the recency of customers at an online

site, because they may be accessing the site from different online service
providers, which will give them a different identification that cannot be compared
to their identifications from previous site visits
...


DIRECT MAIL EFFECTIVENESS RATIO
Description: Direct mail campaigns have a high product design, production, and

mailing cost, so it is crucial to verify the success of these endeavors
...
Consequently,
a company that engages in this form of marketing must pay close attention to the
direct mail effectiveness ratio
...
Under the first approach, po-

tential customers do not place an order at the time of the response to the direct mail
campaign, and must be contacted in order to confirm a sale
...
The formula is:
Number of leads generated
———————————————
Number of direct mail pieces issued

Measurements for the Sales and Marketing Department / 261

If customer orders arise straight from a direct mail campaign, then there will be
orders instead of sales leads
...
Another variation is to compare the gross margin on sales derived from
the direct mail campaign to the total direct mail expense
...
The three variations are:
Direct Mail Sales
———————————————
Number of Direct Mail Pieces Issued
Direct Mail Sales
———————————
Total Direct Mail Expense
Gross Margin on Direct Mail Sales
———————————————
Total Direct Mail Expense
Example: The marketing manager of the Curious Gifts Catalog Company wants

to measure the performance of her latest direct mail campaign
...
5
...
35 (calculated as $842,000 sales, divided by 2,400,000 pieces issued)
...
The most telling comparison is
the ratio of gross margin to the direct mail expense of 1
...

Cautions: If there are multiple direct mail campaigns going on at the same time, it

is easy for sales leads or orders derived from them to be mixed up so that it is impossible to tell which campaign was the most effective
...


Table 13
...
In these cases, customers will likely contact the call center in
order to notify the company that they are canceling their ongoing purchases from
it
...
The inbound telemarketing retention rate can
be used to determine the effectiveness of this activity
...
Depending
upon the situation, this measurement can vary significantly, depending upon
which employee is talking to customers; thus, the measure can be effectively used
to determine differences in the retention rate between employees in the inbound
telemarketing operation
...
It has recently instituted a no-loss program of offering free credit
to any canceling customers for three months, in an effort to drop its cancellations
as close to zero as possible
...
6
...
An additional
analysis at this point would be to determine the amount of profit to be expected
from each customer to see if there is a cost/benefit advantage to retaining customers at this much higher cost
...


For example, a credit card company may offer zero-interest financing on any existing credit card debt for the next few months if a customer agrees to continue

Table 13
...
Consequently, it is useful to also track the cost of
the deals used to retain customers, and then compare this information to the retention rate to see if the customer retention effort is worthwhile
...
This reveals which sales personnel have the best
ability to close a deal once it has been quoted
...

Formula: Divide the dollar value of orders received by the total amount of quoted
orders
...
Also, given the inordinate length of time that customers
sometimes wait before approving an order, this measure needs to be spread over
several months in order to effect a reasonable comparison of quoted to received
orders
...
Its software is difficult for the
sales staff to learn, and so requires a long time period before sales personnel can
become effective sellers
...
Accordingly, the sales manager has compiled dollars quoted and orders received information for two new sales personnel, Mr
...
Browne
...
7
...
7

Brandy – Quotes
Brandy – Orders
Brandy – Quote to close ratio
Browne – Quotes
Browne – Orders
Browne – Quote to close ratio

Jan

Feb

Mar

Apr

$45,000
$6,750
15%
$42,500
$6,375
15%

$63,000
$12,600
20%
$45,000
$5,400
12%

$42,000
$10,080
24%
$41,000
$7,380
18%

$53,000
$14,840
28%
$43,000
$6,450
15%

264 / Business Ratios and Formulas

Based on the quote to close ratios for both sales trainees, it appears that Mr
...
Browne
is not
...
In these cases, it can only be used to measure the closing ability of an entire sales team
...


SALES PER SALESPERSON
Description: Sales per salesperson is the classic measure for determining the

sales effectiveness of the sales staff
...
However,
as noted under the Cautions section, there are several key issues to be aware of that
can make this a misleading measure
...
The resulting measure will only
yield average sales per salesperson within the department, which will hide the
poor performance of any individual sales staff within the group, so one can also
calculate the ratio on an individual basis
...
Also, the measure should include all sales support staff
in the full-time equivalents number in the denominator, even though they are not
actively selling—they are key to supporting the sales staff, and their absence will
impact sales effectiveness, so they should be included
...
Dunriddy and Ms
...

They both have identical total sales, but one is relying on recurring magazine subscriptions for a larger proportion of her sales, which results in a much slower rate
of sales growth for the company
...
8
...
Enoch is the newer of the two
salespeople and is striving to increase sales much more rapidly, so she can derive
a benefit in later years from the commission rate on recurring subscriptions
...
Dunriddy has already built up her recurring subscription base, and
is coasting along with minimal effort to attract new sales
...
8

Recurring sales
New sales
Total sales
Sales per salesperson

Ms
...
Enoch

$150,000
$100,000
$250,000
$250,000

$25,000
$225,000
$250,000
$250,000

incentive for both salespeople, the sales manager reduces the commission on recurring subscriptions and increases it on new subscriptions
...
For example, a salesperson may focus on selling a
product with a high price, rather a lower-priced product that carries a much higher
gross margin
...
A third example is when the sales staff indulges in the excessive use of travel and entertainment
expenses in order to secure sales, once again driving down profitability
...
For all of these reasons,
the sales per salesperson measurement can easily result in salesperson behavior
that does not maximize profits
...


SALES PRODUCTIVITY
Description: Part of the problem with the preceding sales by salesperson mea-

surement is that a salesperson can focus on sales of high-cost, low-margin products in order to make the measure look good, even though the company earns only
a small margin on the sales
...
This is an excellent method for determining
bonuses or employee retention within the sales department
...
This measure should be used for each of the sales staff,
since sales productivity can vary considerably within the department
...
9

Gross revenue
Variable cost of sales
Sales expense
Sales productivity

Salesperson A

Salesperson B

Salesperson C

$1,000,000
$600,000
$150,000
2
...
9:1

$750,000
$375,000
$74,000
5
...
e
...
The sales expense used in the calculation should include the base pay, commission, travel & entertainment, and all other directly
traceable costs of the sales staff
...
The formula is:
Gross nonrecurring revenue –Variable cost of sales
—————————————————————
Sales expense
Example: The manager of a sales department has been informed that one of the

three sales staff must be laid off
...
The manager collections information that
covers the sales performance of the sales staff for the past year that is shown in
Table 13
...

The table reveals that, although Salesperson A sells the most volume, the products have a lower gross margin than those being sold by the other two sales staff
...
This results in the worst sales productivity ratio (of
2
...
Based on this information,
Salesperson A should be laid off
...
Also, this measure does not address the issue of sales being made that
impact a company’s bottleneck production operation; this is covered in the next
measurement
...
If too many

Measurements for the Sales and Marketing Department / 267

products are sold that require a large proportion of constraint time, then a company
will soon find itself unable to increase sales without a large investment to increase
the size of the constraint
...

Formula: Subtract the variable cost of goods sold from gross revenue, and then

divide the result by the amount of constraint time used to produce the items sold
...
In many instances, only material costs are variable, with even direct
labor costs being fixed in the short term
...
The president instructs the
salespeople to shift their efforts into product sales that require less cooker time
...
10 before-and-after information about the salespeople’s performance to see if they are following his instructions
...
The primary change is that the number of hours of cooker time required by the sales has
dropped from 168 hours to 153, which means that the gross margin earned per
hour of constraint time has increased from $1,488 per hour to $1,634 per hour
...

Cautions: It can be difficult to accumulate the information needed to operate this

measurement in an effective manner
...
This can also require a significant revamping of the sales compensation
plan in order to shift salesperson efforts away from usage of the constraint
...
10

Gross revenue
Variable cost of goods sold
Constraint time used
Sales effectiveness

Before

After

$1,000,000
$750,000
168 hours
$1,488/hr

$950,000
$700,000
153 hours
$1,634/hr

268 / Business Ratios and Formulas

SALES TREND PERCENTAGE BY PRODUCT LINE
Description: The marketing and engineering departments need to know how the

sales of each of a company’s product lines are progressing, so that they can alter
their marketing positioning, sales concepts, and product features in coordination
with the perceived position of each product in its life cycle
...

Formula: Subtract total sales dollars in the previous period from those in the cur-

rent period, and divide the result by total sales in the previous period
...
The measure can also be based
on the number of units sold, but ignores the price point at which sales are made,
and so yields less information
...
The formula is:
(Total sales in current period) – (Total sales in previous period)
———————————————————————————
Total sales in previous period
Example: The Nomicon Office Seating Company has designed a deluxe office

chair, the Flexomatic, that has seen skyrocketing sales for the last few years
...
Consequently, the sales manager
wants to keep close track of its sales trend to spot the point at which sales are trailing off
...
11
...
If this reduced sales trend were to continue much longer,
the sales manager might consider dropping the Flexomatic price to become more
competitive with the other models on the market
...
11

Sales
Change in sales from previous period
Sales trend percentage

January

February

March

April

$1,000,000
—
—

$1,500,000
$500,000
50%

$2,250,000
$750,000
50%

$3,000,000
$750,000
33%

Measurements for the Sales and Marketing Department / 269

sues in mind
...


PRODUCT DEMAND ELASTICITY
Description: This is useful for determining the ability of a company to maximize

its profit on product sales by altering prices
...

Formula: Divide the percentage change in quantity of product sold by the per-

centage change in price
...

The formula is:
Percentage change in quantity
—————————————
Percentage change in price
Example: The Meridian Vacuum Company has been selling an industrial-grade

vacuum cleaner for a number of years at a price of $250 per unit
...
At a gross margin of 50%, this means that the product’s price must increase by $50, to $300
...
A marketing
test at this price point reveals that the number of units sold declines from 5,000 to
4,000 as a result of the increased price
...
Consequently, the new price point should
be implemented
...
For example, a customer may pay a higher price simply because it is offered more lenient credit terms by the seller
...
Further, differences in product quality
may shift the buying habits of consumers when faced with otherwise similar products
...
For these reasons, it tends to be difficult to
use this measurement except when large pricing changes are implemented that
will overwhelm all the other factors noted here
...
It is also useful
from a financial planning standpoint, since it shows likely short-term changes in
sales that will impact reported financial results
...

Formula: Determine the amount of annual sales, divide it by 365, and divide the

result into the dollar total of all unfilled sales orders
...
Also, be careful not to include any
projected sales in the backlog figure for which firm orders have not yet been received from customers, since the intent of this measurement is to obtain a realistic understanding of actual orders that have not yet been filled
...
It will only do
this if there is a clear trend of an increasing backlog in sales that can be run
through this type of machine
...
12)
...
This may eliminate the short-

Measurements for the Sales and Marketing Department / 271

Table 13
...
If so, then it still may be
necessary to buy more production equipment if sales levels are expected to increase in the future
...

Also, this can be a misleading measurement, for it ignores the amount of sales that
must pass through a company’s bottleneck operation
...


14
Measurement Analysis with
an Electronic Spreadsheet*

T

here are several tools used to conduct financial analysis
...
However, analysts rarely descend straight into the depths of the accounting database without first using some
more simple means for determining what problem has arisen, which yields clues
regarding where in the database to search
...
To get this information, a calculator, pencil, and paper are sufficient, but also very time consuming
and prone to error
...
In this
chapter, we review how to use such a spreadsheet—in this case, the Microsoft
Excel spreadsheet, version 2000
...
The discussion is confined to the simplest and most understandable spreadsheet commands,
and avoids the use of complicated macros
...
In each case, it is noted how
Excel can be used to solve a problem, and then a sample situation is provided
...
In Excel, a spreadsheet can have a number of interlinked layers known as worksheets
...
This is a preferable approach to using Excel for financial analysis, since one can separate the data
being analyzed in one worksheet, ratios in another, and graphics in yet another
worksheet – but with formulas linking all of them together
...


*This chapter is reprinted with permission from Chapter 14 of Financial Analysis, by
Steven M
...

273

274 / Business Ratios and Formulas

FINANCIAL STATEMENT PROPORTIONAL ANALYSIS
Proportional analysis is simply converting all of the numbers in an income statement
and balance sheet into percentages, so that they can be compared over time to see
what differences arise
...

When using Excel to conduct a proportional analysis of a financial statement,
one must first input the income statement for each period into the worksheet, so
that the proportional analysis calculation will appear below it or on a separate
worksheet
...
1, a simplified income statement has been entered in the
cells at the top of the worksheet
...
For example, the materials cost proportion for the month of
January is calculated with the following formula, which is entered in cell B15:
B5 / B$4
Since the spreadsheet contains the income statement for multiple months, the resulting proportional analysis becomes very useful for finding any trends in the expenses being incurred over the course of the year
...
1 Proportional Analysis of an Income Statement

Measurement Analysis with an Electronic Spreadsheet / 275

The income statement proportional analysis used in the preceding example would
be of great use to management in determining why its profits are not increasing
along with its evident sales growth
...
Why? By perusing the proportional analysis, it is an easy matter to see that the cost of materials has dropped
as a percentage of sales, which may reflect excellent purchasing, design, or production work to lower these costs
...
The direct labor cost as a proportion of sales
has risen, so this is an obvious target area for further analysis
...
Sure enough, the administrative expenses line item reveals a three percent
jump in costs
...

Though this type of analysis is an excellent way to hone in on key areas, it is
rarely the final analysis conducted, since it does not reveal enough information
...
In these cases, it is best to create a number of separate spreadsheets, one for each division, and conduct the analysis on each one, thereby
yielding a greater level of detail regarding problem areas
...
In Exhibit
14
...
The asset percentages sum to the grand total of all assets, while the percentages for liabilities
and equity sum to the total for those two categories
...
In Exhibit 14
...

What does the proportional analysis of the balance sheet tell us? To use the example, there is a clear increase in the fixed asset investment, which requires the
use of all cash, as well as an increased debt load, which reaches its height in May,
after which cash flow from operations is used to gradually draw down the level of
debt
...
Consequently, a great deal can be
discerned by reviewing a proportional balance sheet analysis
...
Typically, a summary form
of the income statement and balance sheet are located at the top of the worksheet,

276 / Business Ratios and Formulas

Exhibit 14
...
By using
this approach, one can quickly enter the summary-level financial information for
the current reporting period and then see the related ratios appear at the bottom of
the worksheet
...
If there are entries for the financial results of previous months,
then one can also see trend lines in ratio results that extend through to the current
reporting period
...
1 and
14
...
A series of ratios are noted in Exhibit 14
...

In Exhibit 14
...
Each
one represents another spreadsheet that is clustered into the same workbook
...

The second tab, entitled BS, contains a spreadsheet version of the balance sheet
...

The formulas behind the ratios in Exhibit 14
...
4 to provide this information
...
3 Ratio Analysis Based on an Income Statement and Balance Sheet

this example, we have eliminated the formulas for all but the month of January,
and then listed each formula in full
...
To obtain this
information, the cell entry goes to the “BS” spreadsheet and adds together cells
B4 and B5, which contain the cash and accounts receivable figures for the month
of January
...

Further down in the list of ratios are ones that are built upon the income statement
...
Finally,
we can mix references to both the IS and BS spreadsheets in the same ratio formula
...
Thus, we can mix cell references from a variety of spreadsheets in order to arrive at a centralized set of ratios that can be stored in a single
spreadsheet location
...
4 Formulas for Previous Ratio Analysis

AUTOMATED RATIO RESULT ANALYSIS
If there are a great many ratios linked to a set of financial statements, one may
want to save time in reviewing them by having the spreadsheet issue a warning
message for those ratios that fall outside a preset parameter
...
In either case, a formula that presents a YES/NO or GOOD/BAD result can save some time
...
To continue with the
example used previously in Exhibit 14
...

Under the Balance Sheet Ratios section, add a row entitled Meets Quick Ratio
Covenant? This is a YES/NO determination based on the quick ratio being greater
than 0
...
The formula for the month of January will be:
IF(B5>
...
The formula for the month of January will be:

Measurement Analysis with an Electronic Spreadsheet / 279

Exhibit 14
...
43,“Yes”,“No”)
Under the Mixed Ratios section, add a row entitled Meets Inventory Turnover
Covenant? This is a YES/NO determination based on the inventory turnover level
being greater than 21 and will appear in row 22
...
5
...
Setting up the IF statements that
drive these automated ratio results are quite simple, and can help to some extent
in the task of sorting through large quantities of ratios
...
There are several types of leverage analysis, all of which can be
converted into formulas and added to a ratio analysis, as will be shown in this section
...
Under this concept, we determine the extent to which a percentage change in sales results in a different percentage change in profits
...
However, if the
bulk of costs are fixed, and will therefore not change when there are changes in
sales, then an increase in sales will result in a more rapid increase in profits
...
This is a wonderful condition to have when sales
are on the increase, since large profit jumps will occur
...
Thus, a large operating leverage
ratio is a two-edged sword that cuts deeply in a declining sales situation
...
The reason for excluding interest and tax
costs is that we are only determining the amount of leverage based on operations,
and neither of these expenses are related to operations
...
3, and is now listed in
an expanded format in Exhibit 14
...


Exhibit 14
...
6 also includes another ratio
...
The measure divides the percentage change in earnings per share by the percentage change in
earnings before interest and taxes
...
Since all of these items are finance-related issues,
we call this the financial leverage ratio
...

The leverage measures outlined here are only general measures, and yield no
more than a high-level understanding of the reasons for changes in profitability
levels
...


TREND ANALYSIS
An electronic spreadsheet is one of the best tools to use for the analysis of trends,
because one can enter a list of time-sequenced data in a spreadsheet and generate
a graphical trend line from it in a few moments
...
To continue with the income statement example shown earlier in Exhibit 14
...
They are shown in Exhibit 14
...

All of the graphs shown in Exhibit 14
...
Go to the IS worksheet in the example and highlight the range of numbers to be
graphed on a trend line
...
Click on the Chart Wizard icon
...
The Chart Type = Column
...
Enter the name of the graph in the Chart Title field
...
Set the Legend option to Off
...
It is
generally best to not store the graph on the current worksheet, since printouts may
inadvertently include the underlying data
...


282 / Business Ratios and Formulas

Revenue Trend Line
2,000
1,500
1,000
500
0
Jan

Feb

Mar

Apr

May

Jun

Jul

Aug

Jul

Aug

Jul

Aug

Gross Margin Trend Line
800
600
400
200
0
Jan

Feb

Mar

Apr

May

Jun

Net Profit Trend Line
200
150
100
50
0
Jan

Feb

Mar

Apr

May

Jun

Exhibit 14
...


Measurement Analysis with an Electronic Spreadsheet / 283

FORECASTING
One is sometimes called upon to make sales forecasts or verify those made by the
sales and marketing departments
...

Though this method of prediction is like trying to drive a car by looking in the rear
view mirror, it is still one of the best tools available, as long as it is supplemented
by detailed conversations with the sales staff to see what is really happening in the
marketplace
...

The first, and simplest, is the TREND command
...
To illustrate the command, we return once
again to the income statement shown earlier in Exhibit 14
...
We will use a new
worksheet within the same spreadsheet, called Trend, and reference in it all of the
monthly sales figures from the previous income statement
...
8, along with a graph that shows the added trend line
...
8, we already know all sales data points from January through August, and want to calculate a trend line that extends an additional
month to give us a prediction for September sales
...
In that cell we enter the following formula:
TREND(B4:B11,A4:A11,A12)
Though it looks complicated, this is a relatively simple command
...
The date for the period to be forecast is noted
in cell A12
...

Another way to state the formula is to ignore the dates and just ask for the next
number in sequence
...
Since the original set of data only included eight data elements, this
will be the next revenue figure after the last month of actual data
...

In order to show this information in a graph, use the same series of steps noted
for the graphs previously presented for Exhibit 14
...
However, to add a trend line
overlay to the presented data, click on the completed graph, move the cursor to the

284 / Business Ratios and Formulas
Sales Trend Analysis
Month
Jan
Feb
Mar
Apr
May
Jun
Jul
Aug
Sep

Revenue
1,200
1,250
1,300
1,250
1,350
1,400
1,450
1,400
1,475

Revenue Trend Line
1,600
1,400
1,200
1,000
800
600
400
200
0
Jan

Feb

Mar

Apr

May

Jun

Jul

Aug

Sep

Regression Analysis
Period
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20

Data Item
43
79
12
18
59
114
3
82
55
31
94
14
87
51
82
23
21
94
11
79

Regression Analysis
120
100
80
60
40
20
0
0

5

10

15

20

25

Exhibit 14
...
Then click on the Add
Trendline option, and pick from six available types of trend lines that can be
added to the graph
...

This is a powerful tool for determining the trend line that best fits a disparate set
of data, and is most useful when dealing with a set of numbers that are widely scattered, and show no apparent pattern
...
Rather than delve into the formula for this method, it is easiest to plot the data
elements and proceed immediately to a graph, on which Excel will superimpose a
regression trend line
...
8, the second half of the presentation includes
the regression analysis
...
The first
step in the analysis is to create a graph, using the same methods noted earlier for
Exhibit 14
...
Then use the same steps just described for the TREND analysis to
add a trend line to the chart
...
8,
where we find that there is a slight upward trend line to the data used to compile
the regression trend line
...
Only for the most unusual analyses, involving wildly disparate data items, will the regression analysis be necessary
...
This trend can spotlight many contributing problems, such as obsolete inventory, returned goods, scrapped parts,
and excess finished goods
...
This analysis should include the net margins earned on each sales channel
...
A company may extend into new geographical regions
without considering the cost of shipping product into those areas
...

Trend of cost of sales calls
...
It is common to find a few high-maintenance customers
who are not worth the sales effort from a cost-benefit perspective
...
Increases in the number of design iterations indicate serious problems in the design process, while a drop in the
trend indicates good design management (though it can also indicate that an insufficient number of product reviews are being made)
...
This can be used in comparison to a market survey
to see if company pay rates are varying from those offered by other firms
...

Trend of engineering change notices issued
...

*Reprinted with permission from pages 296–297 of The Controller’s Function, by Janice
M
...
Bragg (John Wiley & Sons, 2000)
...
Investigate margins by both product and volume
...
These three
items require very high levels of accuracy in order to operate a production planning system
...

Trend of number of product options per product family
...

Trend of overhead capitalization
...

Trend of pricing
...

Trend of product returns
...

Trend of ratio of overhead to production labor
...

Trend of return on shareholders’ equity and return on assets
...

Trend of sales quotas
...

Trend of sales volume
...

Trend of utilized plant capacity
...

So far in this chapter, we have dealt with a variety of analyses that are used primarily for financial statement reviews or budget projections
...


CASH FLOW ANALYSIS
When evaluating a capital asset proposal, there are many factors to review, such
as expected market conditions, sales estimates, salvage values, and maintenance
costs
...
Excel supplies a formula that makes this an easy task, once the
stream of all cash flows has been entered into a spreadsheet
...
9, where we have simulated a typical cash–generating project that involves a significant up-front expenditure to purchase and set up
equipment, five years of progressively larger positive cash flows as more equipment capacity is used, and then additional costs at the end of the project to dismantle the equipment, which is net of salvage value
...

(2) Assumes that positive cash flows will commence half-way into the first year
...

Exhibit 14
...
The
range of cash flow values listed in the second part of the formula represent the net
cash flows for each period of the analysis
...
In the example, the
formula uses a cost of capital of 13%, which results in the following formula:
NPV(
...
For example, the cash flow analysis shown earlier in Exhibit 14
...
In short, one should spend a great deal of time questioning the expected
cash flows used in a net present value analysis in order to be sure of the outcome
...
The other factor is the cost of capital used to discount the stream of
cash flows
...
The simplest way to determine the potential
severity of an error with the cost of capital is to re-calculate the net present value
using a cost of capital that is incrementally higher than the original interest rate
...
A slightly more elaborate
approach, as shown in Exhibit 14
...
Using this graphical approach, we can see that, if the cost of capital increases by just 1% from the 13% used earlier in Exhibit 14
...
Consequently, though the original calculation shows a positive
return, it is so small that a re-examination of the cost of capital may be in order to
verify that the discount rate used is the correct one
...
10 are shown at the bottom of the exhibit, with the text of all formulas noted in the lower right corner
...
9
...
This section only deals with one additional item related to the analysis of a capital asset investment decision
...

Though depreciation does not directly involve cash flow (since it is only the amortization of the original cash outlay for the capital asset), it has an indirect impact
because the depreciation expense in each period will reduce the amount of taxes
paid—and that is a real cash outflow
...
The following list illustrates the formulas for each one, and briefly explain
how each depreciation method works:
Double-declining balance depreciation
...
The formula detail is DDB(Cost, Sal-

Measurement Analysis with an Electronic Spreadsheet / 289

Net Present Value

600

$544
$429

400

$325
$233

200

$150
$75
0

1%

3%

5%

7%

9%

11%

13%

($52)

-200
Cost of Capital

Cost of Capital
1%
3%
5%
7%
9%
11%
13%
15%

Net Present Value
$544
$429
$325
$233
$150
$75
$8
($52)

=
=
=
=
=
=
=
=

Formula Text
NPV($C18,NPV!$H$6:NPV!$H$11)
NPV($C19,NPV!$H$6:NPV!$H$11)
NPV($C20,NPV!$H$6:NPV!$H$11)
NPV($C21,NPV!$H$6:NPV!$H$11)
NPV($C22,NPV!$H$6:NPV!$H$11)
NPV($C23,NPV!$H$6:NPV!$H$11)
NPV($C24,NPV!$H$6:NPV!$H$11)
NPV($C25,NPV!$H$6:NPV!$H$11)

Exhibit 14
...
The Cost part of the equation is the initial cost of the asset
...
The Life part of the equation is the number of periods during
which the asset is being depreciated, which is assumed to be in years
...
For example, if you want to calculate the depreciation for 10
consecutive years, you will need to run the formula ten times, while changing
the Period part of the equation each time to reflect the desired year’s result
...
This method also computes depreciation
at an accelerated rate
...

The descriptions for all of the inputs to the equation are identical to those for
the double-declining balance method
...
This method computes depreciation at the same rate
for all periods, resulting in a smooth and easily calculated depreciation amount
for all periods
...
The formula detail is SLN(Cost, Salvage, Life)
...
However, there is no Period entry, since the
result will be the same, irrespective of the specific period for which you are calculating the depreciation
...
This method provides accelerated depreciation, though not as rapid as provided under the double-declining balance
method
...
Once again,

290 / Business Ratios and Formulas

the descriptions for all of the inputs to the equation are identical to those for the
double-declining balance method
...
This method is essentially the same
as the double-declining balance method, but you can alter the depreciation rate,
as well as convert over to straight-line depreciation at the point where accelerated depreciation results in a lower depreciation expense
...
The descriptions for the first three inputs to the equation are the same as those used for the double-declining balance method
...
The End Period part of the equation specifies
the ending period for which you want to calculate depreciation
...
For example, entering a “2” results in 200% double-declining
depreciation, whereas entering a 1
...
Finally, the Switch to Straight Line
part of the equation allows you to enter TRUE to use declining balance depreciation for all depreciation periods, or enter FALSE to have the formula automatically switch to straight-line depreciation at the point where straight-line
results in a higher depreciation expense
...
Only the underlying formulas will alter the calculated depreciation expense
...
Since increased cash flow now is worth more than cash flow at the end of a
project, an aggressive depreciation method will yield greater project cash flows
...
In this
section, we review several of the most common ones, as well as how to use Excel
formulas to create accurate answers for each scenario
...
If a company is investing money at a consistent rate for a fixed
time period, one may want to know how much that investment stream will be
worth at a specified future date
...
The details of the formula are FV(Interest Rate, Number of Periods, Payment Amount)
...
The Number of Periods component is the number of periods over which a fixed amount is being invested
...

For example, if a company were to invest $4,000 per period for 128 months at
an annual interest rate of 8%, the formula would be FV(8%/12,128,-4000)
...
If a company is offered a specific set of regular payments (i
...
, an annuity), it is useful to see if this results in an adequate rate of return
...

The details of the formula are RATE(Number of Periods, Payment Amount,
Present Value of Payments)
...
The Payment
Amount component shows the amount of each payment
...
For example, if an investor wishes to purchase a
bond with a current value of $100,000 and will pay for it with monthly payments
of $1,500 for 10 years, the formula would be RATE(10,–1500,100000)
...

Loan payment
...
This calculation can also be used to verify the same information that
has been supplied by the lender
...
The details of the formula are PMT(Interest Rate, Number of Payments, Present Value of Loan)
...
The Number of Payments
component represents the number of periods over which fixed payments are to
be made
...
For example, to determine the payment amount
for a loan of $355,000 at an interest rate of 7%, and which will be paid off in
120 periods (e
...
, 10 years), the formula would be PMT(7%/12,120,355000)
...
If there is an obligation to pay a set amount with a standard
number of periodic payments, it may be necessary to determine how long those
payments will last before the obligation to pay has been fulfilled
...
The details of the
formula are NPER(Interest Rate, Payment Amount, Present Value)
...

The Payment Amount component is the amount paid per period, and is also assumed not to vary
...
For example, to determine the number of payment periods required to pay off an investment of $150,000 at an annual interest rate of 12%, and with periodic payments of $28,134, the formula is
NPER(12%,–28134,150000)
...
If a company anticipates receiving a string of payments in future
periods, it may be useful to determine their present value, since this information
can be used to compare the payment stream to the value of other sources of income to see which is more valuable
...
To determine an investment’s present value,
use the PV formula
...
The Interest Rate component is the interest rate per period, and is assumed not to vary
...
The Total Payment Made per Period component is the
payment made in each period, and is assumed to be the same in every period
...
5% interest rate over 20 years, the formula would be PV(6
...

Principal payment
...
This is especially common for capital leases, where the lessor is under no legal obligation
to reveal how much of either payment component is being paid
...
The details of the formula are PPMT(Interest Rate, Period, Total Number of Payment
Periods, Present Value)
...
The Period component is the specific period for which you want to determine the principal payment
...
Finally, the
Present Value component is the amount of the loan at the beginning of
the transaction
...

Given the number of available Excel formulas, it is evident that the majority of
queries that one will receive regarding the time value of money can be answered
by a short formula entry in Excel
...
In this section, we will cover the key interest-rate formulas, including a brief explanation of each one, the components of
each formula, and how the formula is used in an example
...
The formulas are:
Calculate the accrued interest on a security that pays interest at maturity
...
The details of the formula are
ACCRINTM(Issue Date, Maturity Date, Annual Coupon Rate, Par Value)
...
5%
coupon rate bond with a par value of $1,000, the formula would be ACCRINTM(“12/12/99”,“5/15/04”,9
...


Measurement Analysis with an Electronic Spreadsheet / 293

Calculate the accrued interest on a security that pays periodic interest
...
For this calculation, use the ACCRINT formula
...
of Payments per Year)
...

Calculate the annual yield for a discounted security
...
The details of the formula are YIELDDISC(Settlement Date, Maturity Date, Price per $100 Face Value),Redemption Value)
...

Calculate the yield for a Treasury bill
...
The details of the formula are TBILLYIELD(Settlement
Date, Maturity Date, Price Per $100 Face Value)
...
30, then the formula will be TBILLYIELD
(“4/14/05”,“6/15/12”,94
...

Calculate the yield on a security that has a short or long first period
...
To calculate the full-term yield with the odd-length
first period, use the ODDFYIELD formula
...
of
Payments per Year)
...
5%, the price is $98
...
5%,
98
...

Calculate the yield on a security that has a short or long last period
...
The
formula now changes to ODDLYIELD, for which the formula detail is ODDLYIELD(Settlement Date, Maturity Date, Last Coupon Date, Annual Coupon
Rate, Price per $100 Face Value, Redemption Value, No
...
To use part of the preceding example, if the settlement date is May 2,

294 / Business Ratios and Formulas

2003, the maturity date is November 11, 2008, the last coupon date is August
11, 2008, the interest rate is 8
...
25, the redemption value is
$100, and four coupon payments are made per year, then the formula will be
ODDFYIELD(“5/2/03”,“11/11/08”,“8/11/08”,8
...
25,100,4)
...
Some securities
pay all interest at the redemption date, rather than as regular coupon payments
...
The detail for this formula is YIELDMAT(Settlement Date, Maturity
Date, Issue Date, Annual Coupon Rate, Price per $100 Face Value)
...
2%, and the price
is $101
...
2%,101
...

Calculate the yield on a security that pays periodic interest
...
For this situation, use the YIELD
formula
...
of
Payments per Year)
...
5%, the price is
$100
...
5%,100
...

Most of the components of the above formulas are identical
...
The listed coupon rate on a security
...
The first date on which interest is earned on a security
...
The date on which a security is issued
...
The last coupon date for a security prior to its redemption
date
...
The date on which a security expires
...
of payments per year
...

Par value
...

Price per $100 face value
...

Redemption value
...

Settlement date
...


Measurement Analysis with an Electronic Spreadsheet / 295

The formulas described here should be sufficient for calculating the interest rates
or accrued interest for the majority of investment situations for which one will
need to calculate interest earnings
...
Given the level of uncertainty involved, it may be useful to determine the spread of possible outcomes
...
Excel provides a wide array of statistical tools for determining the level of
risk, of which this section describes six that are easy to understand and use
...
For example, if there is a capital project under discussion, try to obtain a number of possible outcomes, either
by polling several experts in the company or industry, or by personal knowledge
of previous actual outcomes for similar types of projects
...
These are shown in Exhibit 14
...
All possible variations are
noted at the top of the worksheet
...
However, these are not very precise measures, and do not
give a sufficiently accurate view of the level of risk
...
Yet another formula
that tells us if there is a “lean” in the data toward the lower or higher end of the
spectrum of possible results is the SKEW formula
...
A skew of zero indicates no skew in either direction
...
The larger the standard deviation of
the sample, the larger the dispersion about the median, and the greater the degree
of risk that the average outcome will not be attained
...
11 are very simple
...
The only variation from this pattern is for the quartile formulas,
which also require the addition of the quartile number at the end of the formula
...
24
$1,808

= SKEW($C$5:$C$16)
= STDEV($C$5:$C$16)

QUARTILE($C$5:$C$16,0)
QUARTILE($C$5:$C$16,1)
QUARTILE($C$5:$C$16,2)
QUARTILE($C$5:$C$16,3)
QUARTILE($C$5:$C$16,4)

Quartile Values
$10,000
$8,000
$8,000
$5,838
$6,000

$4,475
$3,125

$4,000
$2,000

$1,700

$0
1

2

3

4

5

Exhibit 14
...


The analysis shown in Exhibit 14
...
The range of possible outcomes has a positive skew of 0
...
Finally, the standard deviation from the mean is $1,808, which is slightly
more than a 40% variation from the median
...
Also, given the higher degree of risk, the cost of capital used to discount the cash flows from the project may be set higher, thereby
making it more difficult to obtain approval for the project
...
Current liability on the balance sheet, representing shortterm obligations to pay suppliers
...
Current asset on the balance sheet, representing shortterm amounts due from customers who have purchased on account
...
Recording of revenue when earned and expenses when incurred, irrespective of the dates on which the associated cash flows occur
...
Sum total of all deprecation expense recognized to
date on a depreciable fixed asset
...
Any payment received from investors for stock that
exceeds the par value of the stock
...
An offset to the accounts receivable balance, against
which bad debts are charged
...

Amortization
...
This
term is most commonly applied to the gradual write-down of intangible items,
such as goodwill or organizational costs
...
A resource, recorded through a transaction, that is expected to yield a
benefit to a company
...
The beginning inventory for a period, plus the amount at
the end of the period, divided by two
...

Bad debt
...

Balance sheet
...


*Adapted from Appendix E of Accounting Reference Desktop, by Steven M
...


297

298 / Business Ratios and Formulas

Bill of materials
...

Book inventory
...
It comprises the beginning inventory balance, plus the cost of
any receipts, less the cost of sold or scrapped inventory
...

Book value
...

Bottleneck
...

Break-even point
...

Capital
...

Capital asset
...

Capital lease
...

Capitalize
...

The grounds for capitalizing an item include a purchase price that is higher than
a minimum limit (known as the capitalization limit) and an estimated lifetime
for the item that will exceed one year
...
Margin that results when variable production costs are
subtracted from revenue
...

Cost
...
If a product is not
sold, then it is recorded as an asset, whereas the sale of a product or service will
result in the recording of all related costs as an expense
...
Blended cost of company’s currently outstanding debt instruments and equity, weighted by the comparative proportions of each one
...

Cost of goods sold
...
These costs fall into the general subcategories of direct labor, materials, and overhead
...
Typically the cash, accounts receivable, and inventory accounts
on the balance sheet, or any other assets that are expected to be liquidated
within a short time interval
...
Under target costing concepts, the cost that would be applied to
a new product design if no additional steps were taken to reduce costs, such as
through value engineering or kaizen costing
...

Current liability
...

Debt
...

Deficit
...

Depreciation
...

Direct cost
...

Direct labor
...

Direct materials cost
...

Dividend
...
It is authorized by the board of directors
...
Difference between the total of all recorded assets and liabilities on the
balance sheet
...
Payment or the incurrence of a liability by an entity
...
Represents the reduction in value of an asset as it is used for current
company operations
...
Transaction that rarely occurs and is unusual, such as expropriation of company property by a foreign government
...

Factory overhead
...

Fair market value
...

Finished goods inventory
...

Fixed asset
...
It is not purchased with the intent of
immediate resale, but rather for productive use within a company
...
Cost that does not vary in the short run, irrespective of changes in
any cost drivers
...

Fixed overhead
...

Gain
...

Goodwill
...

Gross margin
...

Gross sales
...

Income
...

Income statement
...

Income tax
...

Indirect cost
...

Such costs are frequently clumped into an overhead pool and allocated to various activities, based on an allocation method that has a perceived or actual
linkage between the indirect cost and the activity
...
Cost of any labor that supports the production process but not
directly involved in the active conversion of materials into finished products
...
This is a nonphysical asset with a life greater than one year
...

Interest
...
It can also refer to the equity ownership of an investor in a business entity
...
Any upgrade to leased property by a leasee that will
be usable for more than one year and exceeds the lessee’s capitalization limit
...

Liability
...

Long-term debt
...

Loss
...

Market value
...

Marketable security
...


Glossary / 301

Negative goodwill
...

Net income
...

Net realizeable value
...

Net sales
...

Obsolescence
...
If it is an
inventory item, then a reserve is created to reduce the value of the inventory by
the estimated amount of obsolescence
...

Operating expense
...

Operating income
...

Other assets
...

Owners’ equity
...

Paid-in capital
...

Par value
...
Equity distributions cannot drop the value of stock below this minimum
amount
...
Type of stock that usually pays a fixed dividend prior to any
distributions to the holders of common stock
...
It can, but rarely does, have voting rights
...
Expenditure that is paid for in one accounting period but not
be entirely consumed until a future period
...

Product cost
...

Property, plant, and equipment
...

Quick asset
...
This is
a subset of a current asset, because it does not include inventory
...

Raw materials inventory
...

Retained earnings
...

Revenue
...

Rework
...

Sales allowance
...

Sales discount
...

Salvage value
...

Scrap
...

Share
...

Statement of cash flows
...

Statement of retained earnings
...

Stock option
...
It is a commonly used form of incentive
compensation
...
Person or entity who owns shares in a corporation
...
Price at which one part of a company sells a product or service
to another part of the same company
...
Cost that changes in amount in relation to changes in a related activity
...
Amount of a company’s current assets minus its current liabilities, considered to be a prime measure of its level of liquidity
...
Inventory that has been partially converted
through the production process, but for which additional work must be completed before it can be recorded as finished goods inventory
...
It is intended to be a quick reference for the reader who needs to find a formula as soon as possible
...

The following measurements are listed in the same order as they are found
within each chapter, and the name of each measurement and its derivation are
shown
...

Asset Utilization Measurements
Name

Formula

Sales to working capital ratio

Annualized net sales
—————————————
(Accounts receivable +
Inventory – Accounts payable)

Sales to fixed assets ratio

Annualized net sales
—————————
Total fixed assets
Annualized net sales
———————————
Total fixed assets prior to
accumulated depreciation

Sales to administrative expenses ratio

Annualized net sales
——————————
Total general and
administrative expenses

Sales to equity ratio

Annual net sales
———————
Total equity

Sales per person

Annualized revenue
———————————
Total full-time equivalents
303

304 / Business Ratios and Formulas

Sales backlog ratio

Backlog of orders received
———————————
Sales
Total backlog
——————————
Annual sales / 360 Days

Sales returns to gross sales ratio

Repairs and maintenance expense to
fixed assets ratio

Total sales returns
————————
Gross sales
Total repairs and
maintenance expense
——————————
Total fixed assets before
depreciation

Accumulated depreciation to fixed assets ratio

Accumulated depreciation
———————————
Total fixed assets

Fringe benefits to wages and salaries expense

Life insurance + Medical
insurance + Pension funding
expense + Other benefits
————————————
Wages + Salaries +
Payroll taxes

Sales expenses to sales ratio

Sales salaries + Commissions +
Sales travel expenses +
Other sales expenses
—————————————
Sales

Discretionary cost ratio

Discretionary costs
————————
Sales

Interest expense to debt ratio

Interest expense
————————
(Short-term debt) +
(Long-term debt)

Foreign exchange ratios

Foreign currency gains
and losses
——————————
Net income
Foreign currency gains
and losses
——————————
Total sales

Appendix: Measurement Summary / 305

Overhead rate

Total overhead expense
——————————
Direct labor
Total overhead expense
——————————
Total machine hours

Goodwill to assets ratio

Overhead to cost of sales ratio

Unamortized goodwill
——————————
Total assets
Total overhead expenses
——————————
Cost of goods sold
Total overhead expenses
——————————————
Direct materials + Direct labor
Total overhead expense
——————————
Direct materials

Investment turnover

Break-even point

Sales
——————————
Stockholders’ equity +
Long-term liabilities
Total operating expenses
——————————
Average gross margin
percentage
Total operating expenses –
(Depreciation + Amortization +
Other non-cash expenses)
—————————————
Average gross margin
percentage

Margin of safety

Tax rate percentage

Current sales level –
Break-even point
—————————
Current sales level
Income tax paid
————————
Before-tax income
Income tax expense
—————————
Before-tax income

306 / Business Ratios and Formulas

Operating Performance Measurements
Name
Operating assets ratio

Sales to operating income ratio

Formula
Assets used to create revenue
————————————
Total assets
Operating income
—————————
(Net sales) –
(Investment income)

Sales margin

Gross margin – Sales expenses
—————————————
Gross sales

Gross profit percentage

Revenue – (Overhead +
Direct materials + Direct labor)
—————————————
Revenue
Revenue – Direct materials
————————————
Revenue

Gross profit index

Gross profit in period two
———————————
Sales in period two
------------------------------------Gross profit in period one
———————————
Sales in period one

Investment income percentage

Dividend income +
Interest income
—————————————
Carrying value of investments

Operating profit percentage

Sales – (Cost of goods sold +
Sales, general and
administrative expenses)
————————————
Sales

Operating leverage ratio

Sales – Variable expenses
———————————
Operating income

Net income percentage

Net income
—————–—————
Revenue

Profit per person

Net profit
———————————
Total full-time equivalents

Appendix: Measurement Summary / 307

Cash Flow Measurements
Name
Cash flow from operations

`

Formula
Income from operations +
Noncash expenses –
Noncash Sales
———————————
Income from operations
Net income + Noncash
expenses – Noncash sales
———————————
Net income

Cash flow return on sales

Net income + Noncash
expenses – Noncash sales
———————————
Total sales

Fixed charge coverage

Fixed expenses +
Fixed payments
———————————
Cash flow from operations

Expense coverage days

Cash + Short-term
marketable securities +
Accounts receivable
—————————————
Annual cash expenditures / 360

Cash flow coverage ratio

Total debt payments +
Dividend payments +
Capital expenditures
———————————
Net income + Noncash
expenses – Noncash sales

Cash receipts to billed sales and
progress payments

Cash receipts
—————————
Billed sales + Billed
progress payments

Cash to current assets ratio

Cash + Short-term
marketable securities
—————————
Current assets

Cash flow to fixed asset requirements

Net income + Noncash
expenses – Noncash sales
—————————————
Budgeted fixed asset purchases

308 / Business Ratios and Formulas

Cash flow to fixed asset requirements
(continued )

Cash flow return on assets

Cash to working capital ratio

Cash reinvestment ratio

Cash to current liabilities ratio

Cash flow to debt ratio

Net income + Noncash
expenses – Noncash
sales – Dividends –
Principal payments
—————————————
Budgeted fixed asset purchases
Net income + Noncash
expenses – Noncash sales
———————————
Total assets
Cash + Short-term
marketable securities
—————————
Current assets –
Current liabilities
Increase in fixed assets +
Increase in working capital
———————————
Net income + Noncash
expenses – Noncash
sales – Dividends
Cash + Short-term
marketable securities
—————————
Current liabilities
Net income + Noncash
expenses – Noncash sales
———————————
Debt + Lease obligations
Net income + Noncash
expenses – Noncash sales
—————————————
Total long-term debt payments
for the period

Stock price to cash flow ratio

Dividend payout ratio

(Stock price) × (Number
of shares outstanding)
—————————————
Earnings before interest, taxes,
depreciation and amortization
Total dividend payments
———————————
Net income + Noncash
expenses – Noncash sales

Appendix: Measurement Summary / 309

Liquidity Measurements
Name
Accounts receivable turnover

Formula
Annualized credit sales
———————————
Average accounts
receivable + Notes payable
by customers

Average receivable collection period

Average accounts receivable
————————————
Annual sales/365

Days delinquent sales outstanding

365/Annualized credit sales
from delinquent accounts
————————————
Average delinquent
accounts receivable

Days’ sales in receivables index

Accounts receivable in
period two
——————————
Sales in period two
---------------------------------Accounts receivable in
period one
——————————
Sales in period one

Accounts receivable investment

Average days to payment
——————————— ×
360 Days
Annual credit sales ×
(1 – Gross margin %) ×
(Cost of capital)

Ending receivable balance

Inventory to sales ratio

Inventory turnover

Average receivable collection
period ×
Sales forecast for period
——————————
Days in period
Sales
————
Inventory
Cost of goods sold
————————
Inventory
or,

310 / Business Ratios and Formulas

Inventory turnover (continued )

Cost of goods sold
365 / ————————
Inventory
or,
Direct materials
——————————
Raw materials inventory

Inventory to working capital ratio

Liquidity index

Accounts payable days

Accounts payable turnover

Current ratio

Inventory
—————————————
Accounts receivable +
Inventory – Accounts payable
(Accounts receivable ×
Days to liquidate) +
(Inventory × Days to
Liquidate)
——————————
Accounts receivable +
Inventory
Accounts payable
————————
Purchases / 360
Total purchases
———————————
Ending accounts payable
balance
Current assets
———————
Current liabilities

Quick ratio

Cash + Marketable securities
+ Accounts receivable
————————————
Current liabilities

Cash ratio

Cash + Short-term
marketable securities
—————————
Current liabilities

Sales to current assets ratio

Working capital productivity

Sales
——————
Current assets
Annual sales
———————
Working capital

Appendix: Measurement Summary / 311

Defensive interval ratio

Current liability ratio

Required current liabilities to total current
liabilities ratio

Cash + Marketable securities +
Accounts receivable
—————————————
Expected daily
operating expenses
Current liabilities
———————
Total liabilities
Current liabilities with
required payment dates
——————————
Total current liabilities

Working capital to debt ratio

Cash + Accounts receivable +
Inventory – Accounts payable
—————————————
Debt

Risky asset conversion ratio

Cost of assets with minimal
cash conversion value
————————————
Total assets

Noncurrent assets to noncurrent liabilities ratio

Non-current assets
—————————
Non-current liabilities

Short-term debt to long-term debt ratio

Total short-term debt
—————————
Total long-term debt

Altman’s Z-score bankruptcy prediction formula

(Operating income/Total
assets) × 3
...
999
+
(Market value of common
stock + Preferred stock)/(Total
liabilities) × 0
...
2
+
(Retained earnings/Total
assets) × 1
...
)
Sales expense to sales ratio, 19–20
Sales per person, 11–12
Sales returns to gross sales ratio,
14–15
Sales to administrative expenses
ratio, 9–10
Sales to equity ratio, 10–11
Sales to fixed assets ratio, 7
Sales to working capital ratio, 6
Tax rate percentage, 32–33
Assets to accruals ratio, 107–109
Assets to goodwill ratio, 26–27
Authorized shares to issued shares
ratio, 115–117
Average receivable collection period,
71–72
Backlog, days of, 270–271
Bad debt percentage, 168–169
Bill of material accuracy, 179–180
Billed sales and progress payments to
cash receipts, 56–57
Book value, tangible, 122–123
Book value per share, 121–122
Borrowing base, 99
Borrowing base usage percentage,
177–178
Break-even plant capacity, 234–236
Break-even point, 30–31
Brokerage fee percentage, 175–176
Browse to buy conversion ratio,
258–259
Capacity, break-even plant, 234–236
Capital asset analysis, 288–290
Capital structure and solvency measurements
Accruals to assets ratio, 107–109
Asset quality index, 106–107
Debt coverage ratio, 104–105
Debt to equity ratio, 110–112
Funded capital ratio, 112–113
Issued shares to authorized shares
ratio, 115–117
Preferred stock to total stockholders’
equity, 114–115

Retained earnings to stockholders’
equity, 113–114
Times interest earned, 103–104
Times preferred dividend earned,
109–110
Capitalization rate, 149–150
Cash applied on day of receipt, percentage of, 172–173
Cash flow analysis, 286–8
Cash flow from operations, 49–50
Cash flow measurements
Cash flow coverage ratio, 55–56
Cash flow from operations, 49–50
Cash flow return on assets, 59–61
Cash flow return on sales, 51–52
Cash flow to debt ratio, 64–65
Cash flow to fixed assets requirements, 58–59
Cash receipts to billed sales and
progress payments, 56–57
Cash reinvestment ratio, 62–63
Cash to current assets ratio, 57–58
Cash to current liabilities ratio,
63–64
Cash to working capital ratio, 61–62
Dividend payout ratio, 67
Expense coverage days, 53–54
Fixed charge coverage, 52–53
Stock price to cash flow ratio, 66
Cash flow coverage ratio, 55–56
Cash flow return on assets, 59–61
Cash flow return on sales, 51–52
Cash flow to debt ratio, 64–65
Cash flow to fixed assets requirements,
58–59
Cash flow to stock price ratio, 66
Cash ratio, 87–88
Cash receipts to billed sales and
progress payments, 56–57
Cash reinvestment ratio, 62–63
Cash to current assets ratio, 57–58
Cash to current liabilities ratio, 63–64
Cash to working capital ratio, 61–62
Certified suppliers, percentage of,
208–209
Chart Wizard function, 281–282
Common equity, return on, 127–129

Index / 329

Common shares to stock options ratio,
143–144
Compounding analysis, 290–292
Constraint productivity, 228
Constraint rework percentage, 229
Constraint schedule attainment,
230–231
Constraint utilization, 231–232
Corporate credit card usage, proportion
of, 217–218
Cost of capital, 144–147
Cost of sales to overhead ratio, 27–28
Credit, cost of, 173–174
Current assets to cash ratio, 57–58
Current assets to sales ratio, 88–89
Current liabilities to cash ratio, 63–64
Current liability ratio, 92–93
Current ratio, 85–86
Customer turnover, 256–257
Days delinquent sales outstanding,
72–73
Days of backlog, 270–271
Days sales in receivable index, 73–74
Debt coverage ratio, 104–105
Debt to cash flow ratio, 64–65
Debt to equity ratio, 110–112
Debt to interest expense ratio, 21–22
Debt to working capital ratio, 94–95
Defensive interval ratio, 90–92
Degree of unbalance, 232–233
Depreciation, double-declining balance, 288–289
Depreciation, fixed-declining balance,
289
Depreciation, straight line, 289
Depreciation, sum of the years’ digits,
289–290
Depreciation, variable declining balance, 290
Direct mail effectiveness ratio,
260–261
Discretionary cost ratio, 20–21
Distinct products per design platform,
average number of, 186–187
Dividend payout ratio, 67, 136–137
Dividend yield ratio, 137–138

Earnings per share, 131–132
Earnings per share, percentage change
in, 132–133
Earnings rate on invested funds,
174–175
Economic order quantity, 197–198
Economic production run size,
199–200
Economic value added, 133–136
Electronic data interchange supplier,
percentage of, 209–210
Employee expense report turnaround
time, average, 158–159
Ending receivable balance, 76–77
Engineering measurements
Actual to target cost ratio, 188–190
Bill of material accuracy, 179–180
Distinct products per design platform, average number of,
186–187
Existing parts re-used in new products percentage, 186
Floor space utilization, percentage
of, 192–193
Labor routing accuracy, 181–182
New parts used in new products
percentage, 184–186
New products introduced percentage, 182–183
Products reaching market before
competition, percentage of,
187–188
Sales from new products percentage,
183–184
Time from design inception to production, 191–192
Warranty claims percentage,
190–191
Equipment setup time, average,
240–241
Equity growth rate, 130–131
Equity to debt ratio, 110–112
Equity to sales ratio, 10–11
Equity, return on, 126–127
Existing parts re-used in new products
percentage, 186
Expense coverage days, 53–54

330 / Index

Finance measurements, see Accounting measurements
Financial leverage, 281
Financial leverage index, 129–130
Financial statement ratio analysis,
275–277
Financial statements, time to produce,
162–163
Finished goods inventory turns,
202–203
Fixed assets to accumulated depreciation ratio, 17–18
Fixed assets to maintenance expense
ratio, 248–249
Fixed assets to repairs and maintenance ratio, 15–16
Fixed assets to sales ratio, 7
Fixed assets requirements to cash flow
ratio, 58–59
Fixed charge coverage, 52–53
Floor space utilization, percentage of,
192–193
Forecast analysis, 283–286
Foreign exchange ratio, 22–23
Freight audit recovery ratio, 219–220
Fringe benefits to wages and salaries
expense, 18–19
Funded capital ratio, 112–113
Future value, 290–291
Generally accepted accounting principles, 25–26, 112
Goodwill to assets ratio, 26–27
Gross profit index, 40–41
Gross profit percentage, 39–40
Gross sales to sales returns ratio,
14–15
Inbound telemarketing retention ratio,
262–263
Incoming components correct quantity
percentage, 213–214
Indirect expense ratio, 249–250
Insider stock buy/sell ratio, 139–141
Interest expense to debt ratio, 21–22
Internal audit efficiency, 167–168

Internal audit savings to cost percentage, 165–167
Inventory accuracy, 206–208
Inventory greater than xx days old,
percentage of, 204–205
Inventory to sales ratio, 77–78
Inventory to working capital ratio, 81
Inventory turnover, 78–80
Investment analysis, 292–295
Investment income percentage,
41–42
Investment turnover, 29–30
Issued shares to authorized shares
ratio, 115–117
Labor routing accuracy, 181–182
Leverage analysis, 279–281
Leverage, financial, 281
Leverage, operating, 280
Liquidity index, 82–83
Liquidity measurements
Accounts payable days, 83–84
Accounts payable turnover, 84–85
Accounts receivable investment,
74–76
Accounts receivable turnover, 69–71
Altman’s Z-score bankruptcy prediction formula, 99–101
Average receivable collection
period, 71–72
Cash ratio, 87–88
Current liability ratio, 92–93
Current ratio, 85–86
Days delinquent sales outstanding,
72–73
Days’ sales in receivables index,
73–74
Defensive interval ratio, 90–92
Ending receivable balance, 76–77
Inventory to sales ratio, 77–78
Inventory to working capital ratio,
81
Inventory turnover, 78–80
Liquidity index, 82–83
Noncurrent assets to noncurrent
liabilities ratio, 96–98

Index / 331

Quick ratio, 86–87
Required current liabilities to total
current liabilities ratio, 93–94
Risky asset conversion ratio, 95–96
Sales to current assets ratio, 88–99
Short-term debt to long-term debt
ratio, 98–99
Working capital productivity,
89–90
Working capital to debt ratio, 94–95
Logistics measurements
Certified suppliers, percentage of,
208–209
Corporate credit card usage, proportion of, 217–218
Economic order quantity, 197–198
Economic production run size,
199–200
Electronic data interchange supplier,
percentage of, 209–210
Finished goods inventory turns,
202–203
Freight audit recovery ratio,
219–220
Incoming components correct quantity percentage, 2130–214
Inventory accuracy, 206–208
Inventory greater than xx days old,
percentage of, 204–205
Number of orders to place in a period, 198–199
Obsolete inventory percentage,
203–204
On-time delivery percentage,
223–224
Parts delivery percentage, on-time,
210–212
Payments varying from purchase
order price, percentage of,
214–215
Picking accuracy for assembled
products, 220–221
Production schedule accuracy,
196–197
Products damaged in transit, percentage of, 224–225

Purchase orders issued below minimum dollar level, percentage of,
215–217
Purchased component defect rate,
212–213
Raw material content, 201–202
Raw material inventory turns,
200–201
Receipts authorized by purchase
orders, percentage of, 218–219
Returnable inventory, percentage of,
205–206
Sales through distributors, percentage of, 225–226
Time to ship, average, 221–222
Long-term debt to short-term debt
ratio, 98–99
Machine downtime percentage, unscheduled, 241–242
Maintenance expense to fixed assets
ratio, 248–249
Manufacturing effectiveness, 236–237
Margin of safety, 31–32
Market performance measurements
Capitalization rate, 149–150
Cost of capital, 144–147
Insider stock buy-sell ratio, 139–141
Market value added, 141–143
Price/earnings ratio, 148–149
Sales to stock price ratio, 147–148
Stock options to common shares
ratio, 143–144
Market share, 255–256
Market value added, 141–143
Marketing measurements, see Sales
measurements
Net income percentage, 45–46
Net worth, 119–121
New parts used in new products percentage, 184–186
New products introduced percentage,
182–183
Noncurrent assets to non-current liabilities ratio, 96–98

332 / Index

NPV command, 287–288
Number of orders to place in a period,
198–199
Obsolete inventory percentage,
203–204
On-time delivery percentage, 223–224
On-time delivery ratio, 252–253
Operating leverage, 280
Operating performance measurements
Gross profit index, 40–41
Gross profit percentage, 39–40
Investment income percentage,
41–42
Net income percentage, 45–46
Operating assets ratio, 35–37
Operating leverage ratio, 43–45
Operating profit percentage, 42–43
Profit per person, 46–47
Sales margin, 38
Sales to operating income ratio,
37–38
Operating assets, return on, 125–126
Operating assets ratio, 35–37
Operating income to sales ratio, 37–38
Operating leverage ratio, 43–45
Operating profit percentage, 423
Overhead rate, 24–26
Overhead to cost of sales ratio, 27–28
Parts delivery percentage, on-time,
210–212
Payment discounts missed, percentage
of, 154
Payments varying from purchase order
price, percentage of, 214–215
Payroll transaction fees per employee,
160–162
Picking accuracy for assembled products, 220–221
Preferred stock to total stockholders’
equity, 114–115
Present value, 291–292
Price/earnings ratio, 148–149
Product completion percentage, acceptable, 242–243
Production measurements

Break-even plant capacity, 234–236
Constraint productivity, 228
Constraint rework percentage, 229
Constraint schedule attainment,
230–231
Constraint utilization, 231–232
Degree of unbalance, 232–233
Equipment setup time, average,
240–241
Indirect expense ratio, 249–250
Machine downtime percentage,
unscheduled, 241–242
Maintenance expense to fixed assets
ratio, 248–249
Manufacturing effectiveness,
236–237
On-time delivery ratio, 252–253
Product completion percentage,
acceptable, 242–243
Productivity index, 237–238
Reorder point, 250–252
Scrap percentage, 245–246
Throughput effectiveness, 233–234
Unit output per direct labor hour,
239–240
Warranty claims percentage,
247–248
Work-in-process turnover, 244–245
Production schedule accuracy,
196–197
Productivity index, 237–238
Product demand elasticity, 269–270
Products costed prior to release, proportion of, 164–165
Products damaged in transit, percentage of, 224–225
Products reaching market before competition, percentage of, 187–188
Profit per person, 46–47
Proportional analysis, 274–275
Purchase discounts taken to total discounts, 152–153
Purchase orders issued below minimum dollar level, percentage of,
215–217
Purchased component defect rate,
212–213

Index / 333

Quick ratio, 86–87
QUARTILE command, 295–296
Quote to close ratio, 263–264
Ratio analysis of financial statements,
275–277
Ratio result analysis, 278–279
Raw material content, 201–202
Raw material inventory turns, 200–201
Receipts authorized by purchase orders, percentage of, 218–219
Receivables collected as percent of
dollar value assigned, 171–172
Receivables over xx days old, percentage of, 169–171
Recency, 259–260
Regression analysis, 284
Reorder point, 250–252
Repairs and maintenance expense to
fixed assets ratio, 15–16
Required current liabilities to total
current liabilities ratio, 93–94
Retained earnings to stockholders’
equity, 113–114
Return on assets employed, 123–125
Return on investment measures
Book value per share, 121–122
Book value, tangible, 122–123
Dividend payout ratio, 136–137
Dividend yield ratio, 137–138
Earnings per share, 131–132
Earnings per share, percentage
change in, 132–133
Economic value added, 133–136
Equity growth rate, 130–131
Financial leverage index, 129–130
Net worth, 119–121
Return on assets employed, 123–125
Return on common equity, 127–129
Return on equity percentage,
126–127
Return on operating assets, 125–126
Returnable inventory, percentage of,
205–206
Revenue trend line, 284
Risk analysis, 295–296
Risky asset conversion ratio, 95–96

Sales backlog ratio, 13–14
Sales effectiveness, 266–267
Sales expense to sales ratio, 19–20
Sales from new products percentage,
183–184
Sales margin, 38
Sales measurements
Browse to buy conversion ratio,
258–259
Customer turnover, 256–257
Days of backlog, 270–271
Direct mail effectiveness ratio,
260–261
Inbound telemarketing retention
ratio, 262–263
Market share, 255–256
Product demand elasticity, 269–270
Quote to close ratio, 263–264
Recency, 259–260
Sales effectiveness, 266–267
Sales per salesperson, 264–265
Sales productivity, 265–266
Sales trend percentage by product
line, 268–269
Sales per person, 11–12
Sales per salesperson, 264–265
Sales productivity, 265–266
Sales returns to gross sales ratio,
14–15
Sales through distributors, percentage
of, 225–226
Sales to administrative expenses ratio,
9–10
Sales to equity ratio, 10–11
Sales to fixed assets ratio, 7
Sales to inventory ratio, 77–78
Sales to operating income ratio, 37–38
Sales to current assets ratio, 88–89
Sales to sales expense ratio, 19–20
Sales to stock price ratio, 147–148
Sales to working capital ratio, 6
Sales trend percentage by product line,
268–269
Scrap percentage, 245–246
Short-term debt to long-term debt
ratio, 98–99
SKEW command, 295–296

334 / Index

Spreadsheet, 273
Stock options to common shares ratio,
143–144
Stock price to cash flow ratio, 66
Stock price to sales ratio, 147–148
Stockholders’ equity to retained earnings, 113–114

Total stockholders’ equity to preferred
stock, 114–115
Transaction error rate, 156–157
Transactions processed per person,
155–156
Trend analysis, 281–282
TREND command, 283–286

Tax filing dates missed, percentage of,
163–164
Tax rate percentage, 32–33
Time from design inception to production, 191–192
Time to issue invoices, average,
157–158
Time to produce financial statements,
162–163
Time to ship, average, 221–222
Times interest earned, 103–104
Times preferred dividend earned,
109–110
Throughput accounting, 26
Throughput effectiveness, 233–234
Total current liabilities to required
current liabilities ratio, 93–94

Unit output per direct labor hour,
239–240
Wages and salaries expense to fringe
benefits ratio, 18–19
Warranty claims percentage, 190–191,
247–248
Work-in-process turnover, 244–245
Working capital productivity, 89–90
Working capital to cash ratio, 61–62
Working capital to debt ratio, 94–95
Working capital to inventory ratio, 81
Working capital to sales ratio, 6
Worksheet, 273
Z-score bankruptcy prediction formula,
99–101



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