How to make good use of the paper your accountant gives to you (part 3)

In this post we keep discussing ratios.

In part one we discussed margins; in part two we discussed the current and quick ratios. Now I’m going to illustrate few other tecniques which are helpful for avoiding unpleasant surprises.

One of the various ways to classify your costs is splitting them in costs of goods sold and overheads. The first term is pretty self-explanatory and, given this, the rest are overheads.

A ratio to be monitored is:
(overheads)/(sales)

Sometimes this is called a Defensive Ratio. This ratio gives you a measure of the resources your company absorbs without directly producing an income. What’s important is that this ratio does not increase over time; such an increase measures directly your efficiency in producing money. Having an overhead is normal and it is, somehow, in your company DNA; growing the overhead weight while doing the same things is not.

Another efficiency related ratio is
(gross wages)/(sales)

This is a measure of your people efficiency. While having an amount of money going into wages is normal, its percentage on sales should remain constant over time, if the company business model does not change.

Another interesting tecnique is the Common Size Analysis. Have your accountant place, side by side, this year and previous year same period income statements. Then calculate the percentage of each cost line against the sales. Then have a look at how the incidence of every line changed over time. This will give you a precious insight on how your economic structure has changed in the last year. Your net income may grow because you sell more but you might have sold less efficiently. Your cost structure may change over time and the common size analysis let you analyze it. You should always try to optimize the cost with the higher percentage, but other costs may become more relevant for reasons that you cannot control.

The ratios presented in this short series are only a small fraction of all the ratios you could need to properly control your company. Many ratios are industry specific and go beyond the scope of these short posts.

What I hope is that I have given you a primer of what the figures can do for you. So, the next time your accountant gives you some figures laden papers do not give a casual glance to the bottom line but start working on them. You might be surprised.