Financial Ratio Analysis - One Key to Success

Your Balance sheet contains important data
That will enable you to interpret trends that will help you assess
Overall performance and reveal emerging problems

The ability to analyze business operations by interpreting accounting records is one of the keys to the successful management of an independent community pharmacy. Ratio analysis, utilizing elected items from the balance sheet and the profit and loss statement is one technique employed by many managers for some time to assess overall performance and to reveal emerging problems.

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

Rule of thumb methods should be applied with care since they vary by type of business. Ratios derived from data from a selected group of pharmacies utilizing the Lilly Digest and ratios derived from the internal data of previous years offer the best basis for comparison.

We will show how to compute several of the ratios, discuss each briefly and illustrate their application through a case study. A combination of ratios may prove more enlightening than any one alone. Hence we will group the ratios into these major categories of financial management: liquidity, solvency, inventory control, profitability, and capital efficiency. The two categories will be discussed in this article and the other three categories will be presented in the next edition of U.S. Pharmacist. Only the most common ratios will be presented. A glossary of terms is provided at the end of the article.

Liquidity

1. Current Ratio

The minimum current ratio for pharmacies should be > 2:1

This ratio sometimes called the "net working capital ratio," is intended to give some indication of the pharmacy's ability to pay its bills as they come due. Current assets include cash, accounts receivable and inventory. Current Liabilities include accounts payable and notes payable within one year. The rule of thumb is a 2:1 current ratio. Rule-of-thumb must be applied with care because they apply to businesses in general. Many firms have gone bankrupt with a current ratio of 2:1. Whether or not a firm's current ratio is good or bad 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. The minimum current ratio for pharmacies should be greater than 2:1.

Generally speaking, if the current ratio is too small the pharmacy will encounter problems in paying bills as they come due. On the other hand, a current ratio that is too high may represent excessive cash balances, excessive inventories, or excessive accounts receivables consisting of many slow accounts.

Perhaps the best test to determine the adequacy of the current ratio is a comparison with the average for a number of close competitors from the Lilly Digest; for independent community pharmacy the average ratio for all pharmacies is approximately 3:1.

2. Acid test ratio

Current Assets (Minus) Inventory
Current Liabilities

The acid test ratio offers an easily calculated check on current asset distribution. It is often referred to as the "quick ratio" because it is the ratio of the two current assets most readily available to pay bills; Inventory and cash. If a pharmacy has a large quantity of slow moving inventory as a result of overbuying the situation will not be exposed by the current ratio but will certainly be evident in the acid test calculation. An acid test ratio of one-to-one is considered satisfactory.

3. __Current Liabilities___
Net working capital

This ratio, expressed as a percentage, is another measure of liquidity. A ratio of 50 percent or less is desirable. New pharmacies will usually have a higher percentage than older pharmacies because of high start-up costs and current debts.

4. Average accounts receivable collection period

Ending accounts receivable
(Annual credit sales/365)

One of the most important indicators of current conditions in a pharmacy that provides credit is the speed with which the pharmacy collects its accounts payable. The average collection period (days' sales uncollected) gives an idea of the liquidity of the receivables. According to a rule of thumb, a pharmacy's accounts receivable should not exceed one and one-third times the days in the credit period it grants. If the pharmacy offers 30 day terms then 36.5 days or less is acceptable. If the days' sales uncollected are excessive, it is assumed that some accounts are old and uncollectable.

An important relationship to note exists between the average collection period and the pharmacy's own credit terms. For example, credit term of 30 days and an average collection period of 45 days could be dangerous and costly, for the continued congestion of funds in receivables reduces the flow of cash for reinvestment in inventory. The average time to pay accounts formula is:

Ending accounts payable outstanding
Annual purchase/365

If the debt to net worth is high, you wil have diffuculty in borrrowing addidional funds.

Solvency

1. Total liabilities
Net worth

This ratio frequently referred to as the "debt to equity ratio," is extremely important to creditors because it compares the dollars that creditors have contributed in financing the pharmacy to the dollars the owner's have contributed. It gives some indication of the risk involved in lending money to the pharmacy. An axiom states that the creditors should not have more invested in the business than do the owners. Thus, if the debt to net worth is high, the pharmacy manager will find difficulty in borrowing additional funds. The average for pharmacies is approximately 75 percent.

2. Funded Debt (Long Term Liabilities)
Net working capital (Current Assets - Current Liabilities)

This ratio, along with the previous one, is helpful in determining a pharmacy's potential to borrow. A high funded debt puts a severe strain on the net working capital because from this fund comes the money to amortize the funded debt. The average for pharmacies is approximately 30 percent, and should not exceed 50 percent.

3. Fixed assets
Net worth

This ratio indicates the degree to which the pharmacy has invested its capital in fixed assets, i.e., assets held for sale of goods and services and include such items as land, buildings, equipment, and fixtures. If this figure exceeds 50 percent, too much money is invested in fixed assets and therefore is not available for working capital. The Lilly Digest values for reference in independent community pharmacies is well below 50 percent. It is difficult to correct this problem once it occurs because fixed assets are difficult to liquidate without absorbing a significant loss from the original purchase price. On the other hand a low percentage suggests that remodel may soon be necessary.

The ratios discussed in this article come primarily from data on the balance sheet. In the next edition of U.S. Pharmacist we will examine those ratios derived primarily from the income and expense statement in the managerial areas of inventory control, profitability and capital efficiency.

Total Assets Minus Total Liabilities

Current Rratio: This ratio measures the pharmacy's ability to pay current liabilities as they become due

Acid Test Ratio: This ratio measures the pharmacy's ability to pay current liabilities as they become due with the more liquid current assets, i.e., it omits inventory from the equation.

Financial Ratio Analysis

Why inventory control, profitability and
Capital efficiency ratios can help the pharmacist uncover
Problem areas…and once spotted, how can you correct them.

In the past issue of U.S. Pharmacist, the first of a two part feature on financial ratio analysis covered the ratios derived primarily from the balance sheet in the areas of liquidity and solvency management. This article will cover many of the ratios derived either from the income and expense report alone or from a combination of the two statements in the management areas of inventory control, profitability and capital efficiency. Following a discussion of the ratios their applicability will be illustrated through a case analysis of Galen's Pharmacy.

Inventory Control

1. Inventory Turnover Rate = Cost of goods sold
Average inventory

Inventory turnover rate is an indication of the frequency with which merchandise is sold. The average inventory turnover rate for independent community pharmacies is between four and five although most managers would prefer it to be higher. An inventory turnover that appears to be low may indicate overbuying or an accumulation of obsolete or slow-moving inventory. An inventory turnover that is high (pharmacies rarely have this problem) may indicate incomplete stocks with frequent loss of sales. If the inventory begins to turn very quickly the pharmacy would probably benefit through the purchase of selective deals for quantity discounts. Since inventory is the major investment of the pharmacy it must be closely monitored.

A review of the balance sheet in Galen's shows that it is facing a major liquidity problem.

2. ____Inventory____
Net working capital

This ratio is an additional means of measuring liquidity as well as inventory balance. It is indicative of the efficient use of capital. Too little inventory results in out-of-stock situations; too much inventory decreases the return on investment. The ratio normally is between 75 and 125 percent.

3. ___Net profit___
Inventory

This ratio measures both profitability and the efficient use of inventory. The minimum acceptable value would be approximately 20 with a range of 20 to 40 percent.

Profitability

1. Net Profit
Sales

This is the most frequently used and best understood ratio to indicate the profitability of the community pharmacy. It is a convenient way to compare the performance of the pharmacy with other pharmacies of similar sales and prescription volume by utilizing data in the Lilly Digest. It is also useful in comparing data from the same pharmacy over time. The average net profit in independent community pharmacies according to the 1986 Lilly Digest is 2.8 percent. Since this ratio does not take into account the value of the assets necessary to generate income it is most useful in connection with the next ratio, return on investment (return on equity).

2. _Net profit_
Net worth

This ratio is probably the most important single ratio since it measures how well the owner's funds are being utilized. It is indicative of overall profitability and operational efficiency. This value can be compared with opportunities for investment elsewhere. Whether or not a particular return on investment is acceptable depends upon the investor's own appraisal of risk, but a minimal percentage for community pharmacies would probably be 20 percent.

3. __Net profit__
Total assets

For a new pharmacy with heavy funded debts and relatively small net worth this ratio may provide a more meaningful measure of profitability than the return on investment ratio. The rationale for using this ratio is that it measures the efficient use of all the assets under the control of management. A minimal desirable value is 10 percent.

The average inventory turnover for independents is between 4-5 times per year.

Capital Efficiency

1. ______Sales______
Net working capital

This ratio measures the velocity of business activity. More specifically it is indicative of the efficient use of working capital. The acceptable range is between four and eight. If the ratio is too low business is sluggish and the manager should either reduce working capital to more efficient levels or increase sales to more profitable levels. If the ratio is too high the opposite condition occurs creating a very delicate balance of inflow and outflow of funds. This balance could be easily upset with any interruption caused by a sudden loss of sales or a deterioration in accounts receivables.

2. ___Sales___
Net worth

This ratio is similar to the net working capital turnover ratio above except that the desirable range is between three and eight. The capital turnover is usually less because net worth is usually less because net worth is usually greater than net working capital. A low value indicates inefficient use of owner funds. A high value indicates undercapitalization.

Illustration of Financial Ratio/Trend Analysis

The financial data for Galen's Pharmacy for three consecutive years are presented in Tables 1 and 2. The ratios computed from these data are presented in Table 3 with the ratio averages for the most comparable group of independent community pharmacies from the 1986 Lilly Digest and the rule of thumb standard values. The trend analysis data for Galen's Pharmacy, also computed from the data in Tables 1 and 2, are presented in Table 4. The first eight ratios in Tables 3 and 4 were discussed last month in U.S. Pharmacists. They will be referred to in the final analysis and conclusion of this article. The remaining eight ratios in each tabulation will be introduced and discussed now.

Table 1

Examination of the financial ratios for Galen's (Table 3) reveals an inventory turnover rate of 4.0, equal to the minimum acceptable standard of 4.0 and below the comparable pharmacy average from the Lilly Digest average of 4.8. The inventory to net working capital ratio of 118 percent is above the industry average of 99 percent and is outside of the acceptable standard of 100 percent. All of the ratios involving net profit including the net profit to inventory ratio are unacceptable as the pharmacy lost money in 1986. Both of the capital efficiency ratios are within the acceptable standard range.

The return on investment ratio is the most important single ratio, since it measures how well funds are being used.

Examination of the trend analysis of Galen's (Table 4), shows problems. While the inventory turnover rate has remained relatively stable the inventory to working capital has increased from 92 percent in 1984 to 118 percent in 1986. There has been a dramatic decline in the net profit for Galen's over the three year period to the point where the pharmacy has a net loss of $2000 in 1986. This negative impact is revealed in all of the profitability ratios. The trends for both of the capital efficiency ratios are increasing, an indication that funds have been utilized more rapidly during 1986.

What has happened to Galen's Pharmacy? While the net profit commands the focus of attention it is not the problem with Galen's. It is the consequence of a chain reaction of other less apparent factors. The ratio analysis has indicated major problems in profitability, liquidity and inventory control.

A closer examination of the income and expense statement shows that the pharmacy has been experiencing a decrease in gross margin, from 34.5 percent in 1985 to 33.3 percent in 1986, and an increase in total expenses from 32.4 percent in 1985 to 33.7 percent in 1986. These translate directly into declining net profits.

Table 2

The current ratio, acid test ratio, and liabilities to net working ratios shown in Tables 3 and 4 suggest Galen's may have difficulty paying its bills on time. The profitability that this is occurring is further indicated by the accounts receivable collection period and the accounts payable collection period ratios from the same tables.

Correcting the Decline in Net Profit

In reviewing the balance sheet (Table 1) it is evident the pharmacy is moving in the direction of a major liquidity problem because of its low cash position. The cash account has decreased dramatically, from $20,000 in 1984 to $5000 in 1986, while the accounts receivable account has significantly increased from $25,000 in 1984 to $40,000 in 1986 and the inventory account has increased from $80,000 in 1984 to $105,000 in 1986. Galen's is taking longer to pay its bills because it does not have sufficient cash on hand. A considerable amount of inventory must be sold and/or the accounts receivable outstanding must be collected and turned into cash. Currently liabilities have grown significantly from 1984 to 1986. Accounts payable have increased from $24,000 in 1984 to 1986. Apparently the pharmacy has borrowed some monies to operate as the short term notes are up from $7000 in 1984 to $11,000 in 1986.

Table 3

Customers not paying their bills and increased borrowing to pay creditors directly influence net profit. The income and expense statement indicates that bad debts have increased from $1000 in 1984 to $5000 in 1986; an increase of 400 percent. Interest paid to cover the short term borrowing has increased from $2000 in 1984 to $5000 in 1986; an increase of 200 percent. Furthermore, the cost of goods sold has increased from 64.4 percent of sales in 1984 to 66.7 percent in 1986. Because the pharmacy has had difficulty paying its bills on time it frequently has been unable to take advantage of cash and quality discounts.

Table 4

It should be emphasized that the ratios calculated from the information are not inflexible determinants of success or failure, but serve as general indicators for management review. They are not ends in themselves but possible indicators of what has taken place. They should always be associated with the setting from which they were distributed.

Using Accounting Data to Boost Sales and Profits

Accounting procedures should provide accurate information
as a basis for planning, controlling and safeguarding
money belonging to the business.

The words accounting and bookkeeping are often interchanged by many retailers because there is a fuzzy line of distinction between the two concepts. Bookkeeping is a "means of recording transactions and keeping records." Accounting refers to the recording, classifying, summarizing and interpreting of significant data so that sound financial decisions can be made.

Accounting information and the ability to interpret it permit pharmacists to evaluate past and current overall performance of the business. It lets pharmacist identify problems early enough so that action can be taken to minimize or eliminate them. It helps pharmacists in safeguarding their assets. It allows them to satisfactorily fill out required local, state, and federal reports. And it tells them what their bottom line (net profit) is. The successful pharmacist/manager can hardly exist without accounting information.

What records are required? The answer to that question comes from another…what do we need to know? The financial ratios and analytical tools described in previous "Business First" columns assumed that accurate data were readily available from which to calculate them. A few remarks here will serve to illustrate some of the types of information to be accounted for and some suggestions on how to do that.

The essence of good financial management is using - not losing- money

The Daily Cash Report: The purpose of this record is to assist in checking cash and other receipts, eliminate error at the source and record what took place. It is an analysis of transactions - a record, a comparison with the physical cash count (cash reconciliation) and a record of sums passed to the bank, and so on. It should be designed for ease of use, speed and clarity with headings that correspond to the cash register printer.

The Sales Summary: The amount of each day's receipts gives a very broad indication of very short term business progress - it does not show what has been sold or indicate accurately how much of the revenue contributes to overheads and profit.

Sales vary considerably from day to day and month to month throughout the year - final accounts are required annually to show what has occurred over a 12 month period.

For purposes of cash flow and merchandise control it is necessary to have an accurate "at a glance" picture on a monthly and, for some purposes a weekly basis. This is easily done if each day's transactions are summarized for each department or activity and the figures transferred to weekly or monthly records.

The records take only a few minutes to complete and the work can be done by a staff member during quiet periods. The resultant information makes control easy and accurate, it reduces work at the close of each financial year, it provides valuable information for predicting next year's sales and increasing this year's profit.

Accounting for Outgoing

The essence of financial management is using -not losing- money. Cash flow is of paramount importance - not merely to provide for payment of expenses but to produce maximum profit.

Any business must know:

• How much is available in liquid assets (assets that can be realized without delay);
• How much cash is on hand and how much is due to be received with in specific future periods e.g. next week, next month, next quarter;
• What fixed expenses must be met (how much and when due);
• What is owing to creditors (account payable) and when each of these amounts are due, available discounts for early payment etc..
• Whether accounts presented for payment are fair, accurate and correct;
• What has been paid and when;
• To whom each payment was made and exactly what payment was for;
• How to ensure that payments are correct, not duplicated, not made too soon or too late, that all checks in payment are met when presented to the bank, etc.
  

All these information needs can be the product of a simple routine. The record is designed to save time by obviating time-wasting activity in investigating error form past transactions, and producing simple accounting information fro control of the business, taxation purposes, loan applications and so on. The main requirement is that;

• The procedure is simple
• It is understood by all who use it;
• It is kept up to date at all times

Accounting Routines

Receiving Goods: All goods received should be immediately checked against the invoice, delivery slip or packing slip. Shortages or damage should be noted and reported to the supplier without delay. Deliveries should also be checked against the written purchase order (or on occasions when an order was not made out, with the person who authorized the purchase.) This is to ensure:

• That goods are the correct type, brand, size, and quality;
• That the correct amount has been received (when part orders are sent a note should be made on the order and/or invoice of how much is still to come
• The correct price has been charged and all items correctly totaled (check that any special terms or discounts have been allowed.

Note on the invoice or packing slip any errors, shortages, breakages, etc. and ticket each item or batch of items that the correct. These notes are important, as they will form the basis for any payment or refusal to pay.

What Your Cash Register Can Do For You

It is important to choose as cash register system that, however costly, is capable of providing key sales information.

What The Good Manager Needs To Know

Unpaid invoices are sometimes kept separately on a clip and only filed when they have been fully paid and noted with the payment date and check number. Not any items disallowed for payment.

Statements: Some firms pay for purchases as soon as they receive a correct invoice for goods received. Some accounts are paid without delay in order to qualify for cash discounts; other wait until a monthly statement is received shoeing the total of all invoices for the pored.
In either case, only pay when the items have been found to be correct. Before approving a statement for payment always check that:

• All items shown are correct (from invoices);
• Amounts previously paid have been credited and there is no duplication no entry;
• Returned goods or cancelled orders have not been charged
• Totals are correct;
• Discounts and or special terms have been noted and deducted from the amount to be paid

Petty Cash: Many pharmacist are in the habit of taking small sums of money from the cash register to make unrecorded payments for minor items of expenditure. This procedure is not recommended because:

• These amounts are not always claimed as allowable expenses for income tax purposes.
• Unrecorded amounts confuse cash reconciliation, lead to error and provide an opportunity for dishonesty among employees
• It confuses assessments of sales revenue
• The practice destroys the accuracy that is essential in any well-managed cash center.
  

The most satisfactory way of providing ready money for minor expenses is to operate a simple patty cash account. For those without time to spare for lengthy accounting entries simple methods are best.

Using the Cash Register

The cash register is a key source of information in any pharmacy. It is important to choose a system however costly, that is capable of providing all the required information in a form compatible with the other accounting and merchandise information systems that will be required for effective operation in the foreseeable future.

Using Your Bank System

Let your bank help do the accounting. The bank statement is a ready-made accounting document and valuable record. It cost you money -use it well. Here are some simple rules.

• Don't use the same account for business and private purposes
• Do arrange to be given an up-to-date statement at the same time each week (or day)
• Do check your statement against your checkbook and list outstanding checks and any credits that do not appear on the statement
• Cross refer statement entries with those in you other accounting documents occasionally
• Note on the statement that origin of any credits shoe that are not covered by the paying in book
• Note any debts that are not the result of your drawing check e.g. periodic payments, bank charges, interest charges, corrections and alterations, etc.
• Check that no entries have incorrectly been made (for someone else on your account)
• Keep and bind each statement in correct order
• Apply actual balances to your own estimates of revenue and expenses - Compare with your cash flow budget predictions, and record the balance.

There are universal accounting rules and procedures, which must be followed for your business when determining profit for tax purposes, for example or when financial statements are prepared for presentation to a bank. However, above and beyond these standard requirements, you can have a virtually free hand in tailoring the variety and format of the data to be brought together for your review.