Business ratio

Learn 3 simple business ratios to identify negative trends in your business in less time than it takes to read your favourite newspaper.

Business ratios are tools that help you in evaluating the current performance of your business.  They are also very effective in helping you detect problem areas within your business before they get out of hand.  Business ratios are mathematical relationships between different items in the financial statements.  They are quite simple to calculate and learn, but require that you have some basic knowledge about financial statements.  

Today we will discuss three different types of business ratios, although there many more types that are used in business analysis on a regular basis. 

Liquidity ratios.  These types of ratios measure the ability of a business in meeting its short-term obligations.  One major business ratio under this category is the current ratio, calculated as follows: 

Current ratio = Total Current Assets / Total Current Liabilities 

The higher the current ratio, the more capable the business is in meeting its short-term obligations.  A current ratio which is lower than 1 usually indicates that the business is not able to meet its short-term obligations when they fall due.  Although a low current ratio is not a sign of good financial health, it doesn’t necessarily translate into bankruptcy because there are many different ways that a company can secure short-term financing to meet its emergency needs. 

Leverage ratios. These types of ratios measure the degree to which a business is financed by debt.  One major business ratio under this category is the debt to equity ratio, calculated as follows: 

Debt to Equity ratio = Total Long-Term Debt / Owners’ Equity 

A high debt to equity ratio usually means that a business has aggressively financed its growth with debt.  The risk in this is that the interest costs of the debt will not be covered by the return that is generated by the growth. 

Activity ratios.  These types of ratios measure how effective the business is in using its resources.  One major business ratio under this category is the inventory turnover ratio, calculated as follows: 

Inventory Turnover ratio = Sales / Inventory 

The inventory turnover ratio for a specific operating period essentially shows how many times a business’s inventory is sold and replaced in that period. A low ratio is usually an indication of poor sales or excessive inventories. A high ratio usually indicates a high level of sales or insufficient inventories to meet customer demand. For more information on how to read financial statements, take a look at my article “Impress your bank manager! How to read your balance sheet”.

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Why you should become a company

The New Zealand company tax rate was reduced from 33 to 30 percent from the beginning of the 2008/2009 income year – usually 1 April 2008 for companies with a standard 31 March balance date.

This applies to companies and other entities defined as companies by the Income Tax Act, including incorporated societies and unit trusts.

You’ll probably already know that company tax is the tax paid on the annual profit earned by a company.  The reduction to the company tax rate means most New Zealand companies will pay less tax on the profit they generate next year.

If you currently operate as a sole trader, it’s possible that you may pay more tax than if you operated as a company. 

There are many reasons to operate a New Zealand business under a Limited Liability company, rather than as a sole trader.  I have summarised the key benefits below for you.

Limited Liability

The main advantage of operating as a limited liability company is that risk is redirected from you as an individual to the company (as opposed to you as an individual when you are a sole trader).  A limited liability company is a legal entity in its own right and can hold property in its own name, can sue (and be sued) and usually has an indefinite “life”. 

Shareholders liability for the company’s debts is limited to the amount of the paid capital they introduced to the company.  If a shareholder holds 100 $1 shares, that shareholder’s liability for the company’s debts is limited to $100.  In a sole trader environment, the liability for debts incurred is unlimited, which could mean losing the family home and other possessions.

Registration & Protection of Name/Brand

When your company is formed, no other business or company in New Zealand should be able to reserve a name that is identical or very similar to your own name.  A sole trader has no protection in this sense if they are conducting business under a certain name/brand. That name can be registered by another entity in New Zealand and there is little to no recourse for the sole trader in question. 

Taxation & employing family members

A company provides significant tax benefits.  Individuals pay income tax at the rate of 19.5% on income up to 38,000; 33% on income between $38,000 but below 60,000; and 39% on all income above $60,000.  As previously advised, the company tax rate will be 30% as from 1 April 2008.

By introducing family members as employees and/or shareholders income splitting is possible to enable less tax to be paid at the higher rates. In some cases after individuals reach 60,000 of income, any additional company profits may be able to be taxed at 30% and retained as tax paid profits, thus reduce the total tax otherwise payable.

Approval from the Inland Revenue Department is required BEFORE you can pay wages to a spouse or family member of a sole trader.  Restrictions are placed on the hourly rate which can be paid but with a company there is no such restriction.  The amount of remuneration paid must be market rates.

Continuity

If a shareholder wishes to sell part or all of his or her shares the company continuity is not affected with a new shareholder. This would be different with a sole trader as the business has to be sold..

If you feel that a limited liability company structure may be right for you, please do not hesitate to contact us on 0800 836 836 to help you form one. 

Alternatively, if you would like to form the company yourself, you can do this at www.companiesoffice.govt.nz

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Use your home as a genuine business deduction

Your home office is likely to be one of your biggest business deductions.

Ask any proactive tax accountant or business person and they’ll likely agree with me.  Recorded properly, this is one of the all around best deductions dollar for dollar.

Since you probably work at home, quite a bit, you’ll be saving big money just by creating a work space in your home. To deduct part of your home as a business expense, the home office must be used regularly and exlusively in one of two ways:

Many people who run a small business use an area set aside in the family home for work purposes. If you are doing this, you can make a claim for the area set aside so long as:

*  It is used principally for business use (such as an office or storage area), and

*  You keep a full record of all expenses you wish to claim.

The responsibility for keeping invoices and records for a home office is the same as for any other business expenses you are claiming. You can claim a portion of the household expenses, such as the rates, insurance, power, mortgage interest and depreciation (if you own the house). You must keep invoices for these expenses.

You can only claim the expenses that relate to the area set aside for business. Work out the percentage of the work area, compared to the total floor area of the house. Then apply this percentage to the total house expenses.

Knowledge is power and if you don’t know what you are missing, how do become aware? Most importantly we help you to apply this knowledge and put it to work for you. Even if you’re only self employed on a part-time basis, we can help you tap into enormous savings in your everyday habits. 

Have you tapped into our other fr.e resources yet at: >>>  www.themarketingdude.com <<<

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Why your bank account may not reflect the sales that you have made

If you are just starting out with your small business, it could be that you are not too comfortable with the “ins” and “outs” of financial management. You may have been misled into thinking that your bank account is a good way to measure the sales that your business has made in a certain period of time.

To understand why your bank account is not an accurate reflection of your sales, there are a couple of things that need to be taken into account.

You need to realise that your bank account balance is the result of all the cash debits and credits that your business has incurred in a certain period. Debits are money items that were charged to your bank account and include cheques, cash withdrawals, and direct debits that were used to pay for the various expenses that your business incurred.

For example, if you had to pay rental fees for your office space, you may have written a cheque to your landlord and it would have been deducted from your account balance.

Credits are all deposits that are made to your account. If a customer wants to pay you for some goods he bought, he would pay the money directly into your account.

If you earn any interest on your account, that amount will be credited as well. Your bank balance reflects all the cash that your business earns and pays out, not simply the cash that is generated by sales.

The other thing you need to consider is accounts receivable. Most businesses will allow their customers to pay for their purchases after a certain amount of time has passed from the actual date of purchase. If a business has accounts receivable, it means that the sale has been made, but the money for the sale has yet to be collected.

Since a bank account only shows cash transactions that have already taken place, accounts receivable aren’t reflected in its balance. Depending on the type of industry you’re in, accounts receivable can make up a substantial part of your sales revenue. So referring to your account balance for an indication of how well your sales are doing could lead to false conclusions.

To understand how well your businesses sales are doing, it would be much more advisable for you to look at your profit and loss statement. This financial statement has an item called gross profit incorporated into it which reflects only the revenue that is generated by a businesses sales less any direct costs of production.

For those of you who are interested in learning more about small business accounting have a look at my article How to Prepare a Budget.

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Impress your bank manager! How to read your profit & loss account report

If you are relatively new to the business arena, you’re probably not too good at reading financial statements. But for someone who is planning to start a small business, it is crucial to learn how to read financial statements and understand what they mean.

Today, we are going to discuss one type of financial statement called the profit and loss statement. A profit and loss statement is a summary of your income and expenses over a certain period of time, usually a quarter or a year. The profit and loss statement is important because it helps you to understand the profitability or financial condition of your company over that certain period of time.

The main components of a profit and loss statement are:

Sales – Constitute the total revenue received from the sale of a good.

Cost of goods sold – These are the costs directly linked to the production of the good.

Gross Profit (Loss) – Results when the cost of goods sold is subtracted from sales revenue. The gross profit represents the profitability that is generated by the sales revenue.

Operating expenses – These are the general and administrative expenses that are incurred in the day-to-day running of your business; some examples are employee salaries, advertising costs, and rent.

Operating Profit – Results when all the operating expenses are subtracted from the gross profit. The operating profit represents the profitability that is generated when the daily operating activities of the business are taken into account.

Other income and expenses – These are earnings or expenses that a business would not normally have in its day-to-day operations. A good example could be rent earned from a property or interest that is paid on long-term debt. The expenses are subtracted from the earnings in this component to arrive at a net figure.

Net profit before taxes – Results when the net figure for other income and expenses is either added or subtracted from the operating profit. Net profit shows how profitable the company is after all the different types of expenses have been deducted, that is, before it pays it’s taxes.

Income taxes – This is the amount of taxes the company is obliged to pay.

Net income (loss) – Results when the income taxes have been subtracted from net profit. If the net income is positive, the company has been profitable over the accounting period. This figure represents the overall profitability of the company when every single cost of the business has been accounted for.

The net income is essentially the bottom line and constitutes the amount of money that the company has left at the end of the period.

As a business owner, you should be able to understand how profitable your company is. From the profit and loss statement, you can easily identify which types of costs took the most away from your bottom line and start thinking of ways that you can curb them.

The profitability of your company will also be of interest to banks and lenders. A profitable company shows that it is adept at making the most out of borrowed funds and will have less of a problem securing funds in the future. Now that you see how useful it can be to develop your understanding of this type of financial statement, it would definitely be a good idea to do some additional reading up on the subject.

To get a bigger picture of how some of the components of a profit and loss statement can be used in a budget, have a look at my article called “How to Prepare a Budget”.

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Impress your bank manager! How to read your balance sheet

If you want to do well as a small business owner, it would help you if you could understand the basics of how to read a balance sheet. The balance sheet is an indispensable part of a business accounting information and is essentially a snapshot of a company at a specific point in time.

The balance sheet lets you know what a company owns (“assets”) and what it owes (“liabilities”). It will also tell you how much the business is worth.

The company’s assets can normally be divided into current assets and non-current assets. Current assets have a high liquidity value and can be turned into cash quickly. Some examples of current assets which are stated in a balance sheet are cash, accounts receivable (also called debtors), and inventory.

Non-current assets, on the other hand, cannot be easily converted into cash. Some examples of non-current assets are machinery, buildings, or real estate.

The company’s liabilities can also be divided into current and long-term liabilities. Current liabilities are debts that the company must pay back in less than a year. Some examples are accounts payable and 12 months of interest payments on longer-term loans. Long-term liabilities are debts that are due after a minimum of one year.

Shareholder’s equity is made up of the money that was invested into the business at its start and retained earnings. Retained earnings are profits that are not paid out to the company’s owners but are re-invested into the company. Shareholder’s equity is the company’s net worth.

So now that you understand the basic components of the balance sheet, let’s take a look at what types of analysis can be generated from it.

The information in a balance sheet is used to generate many different types of financial ratios. Though we will not get into the mechanics of these ratios in this article, it is important that you understand that they are used to gain insight into many diverse aspects of the business.

Debt-to-equity ratios, for example, will show how extensively the company relies on debt to finance its growth. Financial strength ratios will tell you how good the company is at repaying its debts.

In conclusion, the balance sheet’s purpose is to let you know the business’ financial health and liquidity at a selected point in time.

Investors and lenders prefer that the current assets of a company are higher than the current liabilities because it means the company will remain solvent in the immediate term. Cash shortages are then unlikely and the company will not have to rely on additional funding to meet its obligations.

If you dig a little deeper into the types of analysis that can be done with balance sheet items, you just might be fascinated. With a little basic knowledge, you’ll impress you bank manager and even your accountant!

If you are interested in learning more about how to measure the health of a company, read my article called the “Top 5 Warning Signs that your Business is Declining”.

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Why estate & inheritance planning is so important

Imagine how you would feel if you lost all of your hard earned assets & wealth to a 3rd party or to your offspring’s estranged spouse?  Not a pleasant thought is it?

It’s a scary thought but so many families leave their inheritance and estate planning to chance.  This article introduces some increasingly popular asset protection, estate planning and tax reduction strategies to protect and manage a family’s assets.

Trusts originated in feudal England centuries ago when the King rewarded his Knights with land after they returned home from battle.  To protect their estates from outsiders, the Knights bequeathed their estates to their trusted fellow Knights for them to control their estates for the benefit of their loved ones.

Not much has changed since in asset protection and estate planning.

A family trust is simply a legal obligation created by a person (“Settlor”) who gives the assets in control to another (“Trustee”) for the benefit of another (“Beneficiary”).  A trust deed is formed to document the “rules” that the trust must operate within.

The more common reasons for establishing a family trust include:

• Offering asset protection for family members by transferring ownership of some assets to a trust (commonly the family home).  Some business owners may be exposed to high levels of risk and may decide to protect their family home from future creditors
• Providing some level of estate planning by ensuring certain assets (for example: the family home, business or farm) are transferred intact to the next generation
• To make sure some assets are retained for other family members when one, or more of them needs rest home or hospital care
• To protect family members or a family business from possible relationship property or family protection (contesting a will) claims
• To manage the assets of someone who is unable to manage their own affairs, perhaps through age or infirmity
• To manage tax liability through income splitting

If you would like to establish a family trust, it’s important that you understand your trust and what trustees are responsible for before you establish it.  You should talk to your accountant or solicitor to ensure that the terms of your trust fully meet your needs & fulfil the intended purpose and will not be exposed to tax authority scrutiny.

You should assess whether a family trust is a suitable vehicle to meet your objectives.  You should also weigh up the advantages and disadvantages of your various options, including any ongoing management compliance costs of each. Your accountant or solicitor will be able to help you determine what is required to meet your needs.

Like many professional people, your accountant or solicitor charges for their time, experience and skill in looking after your affairs.  Ask them at the outset how much it is likely to cost or tell them that you don’t want to spend more than a specific amount.
 

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The difference between a margin and a mark-up

I am often asked what the difference is between a margin and a mark-up. 

They actually refer to the same thing and it really depends from what perspective you are looking at. 

A margin is the difference between the cost of your product and how much you sell it for.  Mark-up is the amount you add to the cost of your product to arrive at a selling price, so the 2 amounts are actually the same.  However, the difference as a percentage are NOT the same.

Let’s look at an example:

You buy a product for $10 and sell it for $14 and therefore your profit is $4.

The profit margin is 28.6%, which is $4 / $14 

The mark-up is 40%, which is $4 / $10.

Margins and mark-ups are two important ratios for any business selling a product.  They define the amount of profit that you make from your product.  You can use these ratios as guides for setting your prices and to compare those of your competitors or industry.  Traditionally, mark-ups are usually expressed in dollars (ie a $20 mark up) and margins are expressed as percentages (ie a gross profit of 20%).

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Equipment: Lease versus Purchase

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Let’s put tax cuts in terms everyone can understand.

Suppose that every day, ten men go out for beer and the bill for all ten comes to $100.

If they paid their bill the way we pay our taxes, it would go something like this:

The first four men (the poorest) would pay nothing.

The fifth would pay $1.

The sixth would pay $3.

The seventh would pay $7.

The eighth would pay $12.

The ninth would pay $18.

The tenth man (the richest) would pay $59.

So, that’s what they decided to do.

The ten men drank in the bar every day and seemed quite happy with the
arrangement, until one day, the owner threw them a curve. “Since you
are all such good customers,” he said, “I’m going to reduce the cost
of your daily beer by $20.”Drinks for the ten now cost just $80.

The group still wanted to pay their bill the way we pay our taxes so
the first four men were unaffected. They would still drink for free.
But what about the other six men – the paying customers? How could
they divide the $20 windfall so that everyone would get his ‘fair
share?’

They realized that $20 divided by six is $3.33. But if they subtracted
that from everybody’s share, then the fifth man and the sixth man
would each end up being paid to drink his beer.

So, the bar owner suggested that it would be fair to reduce each man’s
bill by roughly the same amount, and he proceeded to work out the
amounts each should pay.

And so:

The fifth man, like the first four, now paid nothing (100% savings)

The sixth now paid $2 instead of $3 (33%savings).

The seventh now pay $5 instead of $7 (28%savings).

The eighth now paid $9 instead of $12 (25% savings).

The ninth now paid $14 instead of $18 (22% savings).

The tenth now paid $49 instead of $59 (16% savings).

Each of the six was better off than before. And the first four
continued to drink for free. But once outside the restaurant, the men
began to compare their savings.

“I only got a dollar out of the $20,”declared the sixth man. He
pointed to the tenth man,” but he got $10!”

“Yeah, that’s right,” exclaimed the fifth man. “I only saved a dollar, too. It’s unfair that he got ten times more than I!”

“That’s true!!” shouted the seventh man. “Why should he get $10 back
when I got only two? The wealthy get all the breaks!”

“Wait a minute,” yelled the first four men in unison. “We didn’t get
anything at all. The system exploits the poor!”

The nine men surrounded the tenth and beat him up.

The next night the tenth man didn’t show up for drinks, so the nine
sat down and had beers without him. But when it came time to pay the
bill, they discovered something important. They didn’t have enough
money between all of them for even half of the bill!

And that, boys and girls, journalists and college professors, is how
our tax system works. The people who pay the highest taxes get the
most benefit from a tax reduction. Tax them too much, attack them for
being wealthy, and they just may not show up anymore. In fact, they
might start drinking overseas where the atmosphere is somewhat
friendlier.

For those who understand, no explanation is needed. For those who do not understand, no explanation is possible.

An excerpt from:  David R. Kamerschen, Ph.D. Professor of Economics University of Georgia

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