Analyzing Your Business: Ratios/trend Analysis and Credit Management

Article excerpt

Sound financial decisions can be made only through the proper use of reliable financial data. The two basic reports available are:

* THE INCOME AND EXPENSE STATEMENT--the sales and expense report over a specified period of time, usually one year

* THE BALANCE SHEET--a financial picture of the business at a given point in time

The ability to analyze business operations by interpreting these accounting records is one of the keys to the successful management of a pharmacy.

The calculations are not difficult to perform, and they require only a little time and effort.

We will examine two different ways of analyzing these financial statements:

1. RATIO ANALYSIS: Computing a series of ratios from selected numbers on the two financial statements.

2. TREND ANALYSIS: Comparing the two statements to an internal standard--the statements from previous years.

After we have done the ratio analysis and the trend analysis, we will review the managerial aspects of one of the most critical areas of financial management for most community pharmacies: credit management.

FINANCIAL RATIO ANALYSIS

Financial ratio analysis, the utilizing of elected items from the balance sheet and the profit and loss statement, is one technique employed by managers to assess overall performance and to reveal emerging problems.

Financial ratio analysis is not difficult to do. It is a way of expressing various statistics from the financial statements and their relationship with each other.

How many ratios are there? There can be lots of them. Most texts list 20 or more. Each provides valuable information. However, in pharmacy management there are only a few that should be calculated on a regular basis.

The pharmacy manager must determine whether the ratios are good, bad, or average. Three basic approaches for comparison include the use of:

* rule-of-thumb standards

* ratios from a selected group of pharmacies

* ratios from previous years

Rule-of-thumb methods should be applied with care, since they relate to business in general. For example, a rule of thumb for the current ratio is most frequently stated as "2 to 1." Many firms have gone bankrupt with a current ratio of 2:1. Whether or not a firm's current ratio is good depends upon such factors as the nature of the company's business, the distribution of its current assets, and the turnover rate of certain of its assets.

Ratios derived from data from a selected group of pharmacies, utilizing the Lilly Digest, offer a better basis for comparison; however, this section is not as detailed today as it was several years ago.

Ratios derived from the internal data of previous years offer the best basis for comparison and will be extensively reviewed under trend analysis.

We will compute several of the most common ratios and discuss each briefly. Since the essence of management is in doing and not in knowing--to manage is an active verb--you can later compute and analyze the ratios from your financial statements.

An examination of a combination of ratios by area of financial management may prove more enlightening than looking at any one ratio alone. For example, review all of the ratios involving net profit as a group. We will group the ratios into the following categories:

* Liquidity and solvency

* Inventory control

* Profitability

* Capital efficiency

LIQUIDITY AND SOLVENCY

Liquidity refers to the pharmacy's ability to convert its current assets into cash and to pay its current bills. Solvency refers to the pharmacy's ability to pay the interest and to meet repayment schedules associated with long-term debts. The numbers to compute these liquidity and solvency ratios are taken from the balance sheet.

1. CURRENT RATIO:

Current Assets/Current Liabilities Current assets include cash, accounts receivables, and inventory. …