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Consolidated Earnings Statement
For Year Ended December 31, 19XX


Net sales $38,028,500
Cost of goods sold:
Inventory, January 1 4,190,000
Purchases (net) 25,418,500
Goods available for sale 29,608,500
Less inventory, December 31 3,250,000
Cost of goods sold: 26,358,500
Gross profit 11,670,000
Operating expenses
Selling:
Sales salaries expense 1,991,360
Advertising expense 3,527,650
Sales promotion expense 987,745
Depreciation expense”
selling equipment 403,850 6,910,605
General and administrative:
Office salaries expense 1,124,650
Repairs expense 112,655
Utilities expense 39,700
Insurance expense 48,780
Equipment expense 63,750
Interest expense 211,020
Misc. expenses 650,100
Depreciation expense”
office equipment 73,900 2,324,555
Total operating expenses 9,235,160
Earnings before income tax 2,434,840
Income tax 925,239
Net income $1,509,601

Common stock shares outstanding: 2,500,000
Earnings per share of common stock: $0.60
50 THE AGILE MANAGER™S GUIDE TO UNDERSTANDING FINANCIAL STATEMENTS


pany makes on each $1.00 of net sales. A.I. made 4 cents of net
income on each dollar it collected in net sales. Is that good or
bad? It depends on what™s typical for A.I.™s industry.
In the supermarket industry, two to five cents on each dollar
of net sales is about average year in and year out. Maybe that™s
why you see delicatessens, fast-food restaurants, pharmacies,
flower shops, bank branches, and plastic surgery salons now ap-
pearing inside many of the larger supermarkets near you. Those
operations return a higher profit on each dollar of net sales and
make up for the grocery business™s meager profits. (We™re only
kidding about the plastic surgery salons, but they™re probably in
the works. Don™t forget where you heard the idea first!)
Chipmaker Intel, on the other hand, has been known to make
upwards of 25 cents on each dollar of revenue”now there™s an
avaricious industry!
Incidentally, the formula above also yields a figure for some-
thing you™ve probably heard of”net profit margin. It™s expressed
in percentage form. AI™s net profit margin is thus 4 percent.
Let™s detour here for a moment and use this ratio to make several
points about figuring and understanding ratios in general.
When the ingredients are named in the title (as in “ratio of
s

net income to net sales”) put the first item above the line
and the second one below. That™s a handy memory key in
case you™re ever caught without this book (God forbid!).
Once you™ve set it up, Always divide the lower number
s

into the upper one. (Put another way, always divide the
upper number by the lower number.) That™s Straub™s first
law of ratio math. If you do it the other way, you™ll be dead
wrong, and full-time financial types will sneer as you walk
past the water cooler.
When you get the answer, write it down and put it the
s

form “ : $1” because ratios compare one thing to another.
So much for mechanics. Now here™s how you interpret any
ratio:
Financial Analysis: Number-Crunching for Profit 51


”The first number in your answer always refers to whatever
was above the line (in this case, net income) and the 1 always
refers to whatever™s underneath (in this case, net sales).
”Lots of folks like to express ratios in money instead of bland-
sounding numbers, because people really tend to listen up when-
ever money™s involved. No surprise, huh? So we™ll be talking
ratios in money here.
Now, back to the show.
Ratio of Net Sales to Net Income. This flip-flops the two
ingredients used above, but you™ll still get some useful informa-
tion. A.I.™s ratio is:
Net sales $38,028,500
= = $25.19 : $1
Net income $ 1,509,601
This ratio tells you that A.I. had to take in $25.19 in net sales
to make a dollar of profit. That™s how hard the company has to
work to make a buck.
So if $1.00 out of every $25.19 of net sales ended up as net
income, where did the other $24.19 go? Well, some went to
cover the cost of the goods that were sold, and the rest went to
pay expenses.
Remember now, don™t jump to conclusions about any of this
information until you get a comparative figure from a reliable
source. What looks good for a company in one industry may be
not so good for a company in a different line of business. Once
you found out what the typical ratio of net income to net sales
was for A.I.™s industry, though, you™d know if Avaricious had to
work harder or easier than its typical competitor to make a dol-
lar of profit.
Inventory Turnover. This is a theoretical figure. It™s the num-
ber of times the company sold out to the bare walls and replaced
its average stock of goods this year. A.I.™s inventory turnover is:
Cost of goods sold
Average inventory (beginning inventory + ending)/2
52 THE AGILE MANAGER™S GUIDE TO UNDERSTANDING FINANCIAL STATEMENTS


$26,358,500
= 7.09 times
($4,190,000 + $3,250,000)/2

Note that inventory turnover isn™t expressed as a ratio, per-
cent, or some other way. You™d simply say that A.I. turned over
its average stock of goods 7.09 times this year.
A “good” turnover figure depends on what line of business
you™re in. Jewelry stores, for example, may be lucky to turn over
(sell out) their average inventory once a year. Supermarkets and
health-food stores, which sell per-
BT ishable items, turn over their in-
est
ip ventory dozens of times in a year.
Get a comparative figure for your
Low turnover often indicates
line of business.
that the company has too
What if turnover™s low? A turn-
much of the wrong kind of
over that™s lower than the indus-
goods.
try average may mean the com-
pany is carrying too much inven-
tory, trying to sell the wrong stuff, or isn™t doing as good a mar-
keting job as its competitors.
Any combination of these situations would lower turnover
and be bad news:
1. If the company™s carrying too much inventory, it™s tying
up money unnecessarily (not to mention storage space and the
people who keep records). Also, it has to pay interest on the
funds it probably borrowed to pay suppliers.
2. An overstocked inventory means potential trouble if the
company is selling seasonal or fashion merchandise that may be
hard to unload later. (Just try selling snowmobiles in midsum-
mer or marketing bell-bottom slacks or Nehru jackets to today™s
youth.)
3. Low turnover caused by the wrong selection of inventory
means management may be out of touch with what the company™s
customers want to buy”stubbornly trying to sell them widgets
when they really want gadgets, for example.
Financial Analysis: Number-Crunching for Profit 53


What if turnover™s high? A turnover that™s higher than the in-
dustry average may mean that the company™s doing a better
marketing job than its competitors, and that would be cause to
throw a party. But before management starts sending out invita-
tions, a high turnover could also mean that the business is stock-
ing a lower average inventory than it should and not buying in
large quantities. That could mean three things:
1. It™s not getting the highest possible quantity discounts from
suppliers.
2. It may be paying higher freight charges, because buying
often and in small amounts usually forces you to ship by the
most expensive methods.
3. It™s paying too much. When prices are rising (as they usu-
ally are) buying often and in small quantities means you™ll pay
successively higher prices every time you buy.
So a higher-than-average turnover might be good or bad. Man-
agement won™t know which until they check records, search
their souls, call a few meetings, and reward or scare the hell out
of whoever might be responsible, depending on the case.
Note: Although wholesalers and retailers must often carry a
large inventory to accommodate the demands of their custom-
ers, manufacturers attempt to keep their inventories at a mini-
mum. The practice of just-in-time inventory management in
manufacturing has produced sizable savings in storage space,
materials handling equipment, interest paid on borrowed funds,
and other costs associated with carrying an inventory of materi-
als and parts that go into an end product.
In the case of manufacturers, then, a zillion inventory turns
could mean great things for a company.

Analyzing a Balance Sheet
Now let™s revisit Figure 3-1 (it™s on the next page) and pull
off whatever numbers we need from there.
Current Ratio. Find this by dividing A.I.™s current assets by
its current liabilities.
54 THE AGILE MANAGER™S GUIDE TO UNDERSTANDING FINANCIAL STATEMENTS


Avaricious Industries
Balance Sheet
December 31, 19XX

ASSETS
Current assets
Cash and cash equivalents $1,271,231
Accounts receivable 1,032,409
less allowance for
doubtful accounts 38,000 994,409
Notes receivable 350,000
Merchandise inventories 3,250,000
Total current assets 5,865,640
Property and equipment 17,841,980
Less accumulated depreciation 4,173,130
Net property and equipment 13,668,850
TOTAL ASSETS $19,534,490
LIABILITIES
Current liabilities
Accounts payable 1,275,300
Salaries payable 330,000
Income taxes payable 925,239
Other accrued expenses 8,000
Total current liabilities 2,538,539
Long-term liabilities
Mortgage payable 500,000
Bonds payable 2,400,000
Total long-term liabilities 2,900,000
TOTAL LIABILITIES 5,438,539
STOCKHOLDERS™ EQUITY
Common stock, 2,500,000 shares
at $1 par value per share 2,500,000
Capital in excess of par value 1,750,000
Retained earnings, January 1, 8,386,350
Net income for year 1,509,601
Less dividends (50,000)
Retained earnings, December 31, 19xx 9,845,951
TOTAL STOCKHOLDERS™ EQUITY 14,095,951
TOTAL LIABILITIES AND
STOCKHOLDERS™ EQUITY $19,534,490
Financial Analysis: Number-Crunching for Profit 55

Current assets $5,865,640
= = $2.31 : $1
Current liabilities $2,538,539
The current ratio is a measure of safety. It tells you how many
times the company could pay its current debts if it used its cur-
rent assets to pay them with.
A.I.™s current ratio looks pretty solid. The company has $2.31
in current assets standing behind
BT
each $1 it owes in current debts. est
ip
If this ratio were above, say,
$3 : $1, it would imply that man- The acid-test ratio is a more
agement had too many current
realistic and practical measure
assets (perhaps cash or inventory)
of ability to pay current debts
that were just sitting there like a
than the current ratio.
roomful of freeloading relatives
instead of helping to make prof-
its for the stockholders.
A current ratio may give you a false sense of security, though,
because it includes some current assets (like inventory, for ex-
ample) that can be hard to get rid of in a hurry if creditors are
breaking down your doors. So a more realistic ratio that high-
lights a company™s ability to pay its current bills is the next one.

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