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Chapter Eight: Financial Analysis
D. Leverage ratios
i Ratios that are used to examine the relative level of indebtedness of
the entrepreneurial business
ii. Three ratios evaluate the level of indebtedness of a business
1. Debt-to-Equity
a. Ratio provides data about the portion of the
business owned by lenders versus the portion of
business owned by the owner or founder of the
business
i. Total liabilities divided by total assets minus
total liabilities
2. Debt-to-Assets
a. Measures the percentage of the assets of the firm
that are actually owned by creditors
b. Total liabilities divided by total assets
3. Times Interest Earned
a. Figure estimates the number of times that the firm
could repay the current interest owed on its debts.
b. Higher number indicates the firm is more capable
of servicing its debt load
c. Operating income divided by the interest
iii. Calculating leverage ratios
1. Refer to the balance sheet illustrated in Figure 8.1 on page
145 of the text to provide example about how to calculate
the leverage ratios
2. Refer to the income statement illustrated in Figure 8.2 on
page 146 of the text to provide example about how to
calculate the times interest earned ratio
3. Significant changes in the debt-to-equity ratio and the
times interest earned ratio are of particular interest to the
business owner
a. The owner compares this data with industry
averages to reveal if there are changes in the
particular industry
E. Profitability ratios
i. Ratios that examine the performance of the firm and its ability to
make economic rents over and above its costs
1. Gross profit margin
a. Gross profit divided by net sales
b. Used to determine the overall profit obtained from
sales during a specific period of time
IM 8-1
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written consent of McGraw-Hill Education.
Chapter Eight: Financial Analysis
c. Calculated by taking the total net sales of the firm
and subtracting the returned merchandise as well
as the direct cost of the goods sold
2. Operating profit margin
a. Operating income divided by net sales
b. Gross profit minus all operating expenses
c. Also known as Earning Before Interest and Taxes
(EBIT)
i. Represents the operating efficiency of the
organization
3. Net profit margin
a. Net profit divided by net sales
i. Bottom line calculation from the income
statement
ii. Figure represents a view of the relative margin
earned after all obligations and expenses are
considered
4. Return on assets (ROA)
a. Net profit divided by total assets
i. An industry standard calculation
ii. Examines the ability of the firm to return an
overall profit compared to the amount of assets
that the firm has invested
5. Return on equity (ROE)
a. Net profit divided by equity
i. Provides investors with an evaluation of how
much each dollar of their investment generates
a profit
i. Calculating profitability ratios
i. Review the income statement on page 146 of the text, figure
8.2
F. Summary of Ratios
i. Ratios are valuable assets to a firm
ii. Statements are standard with a variety of accounting packages
iii. Accounting packages may calculate ratios
iv. Small business owners understand the ratios and they only use
one or two few ratios in each category to assure conciseness
1. Liquidity
2. Activity
3. Leverage
4. Performance
5. Profitability
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written consent of McGraw-Hill Education.
Chapter Eight: Financial Analysis
v. Small business owners compare the ratios with other firms in
their industry over a specific time period in order to interpret the
outcome of the ratio analysis
6. Deviation Analysis (text page 153)
Learning Objective 8-5: Explain Deviation Analysis.
A Deviation analysis
i. Analysis of the differences between the predicted and the actual
performance.
ii. Deviation analysis is the second method used to evaluate the firm,
its activities, and its performance
iii. The time period associated with deviation analysis is typically
month to month or year to year
iv. A Deviation chart has two additional columns that ensure all
important metrics are maintained
1. Column to show the actual change
2. Colum to show a percentage of change
v. Ratios reveal data based on perception analysis
1. A drop in the current ratio from one year to the next can be a
negative indicator
2. At the same time, a drop in the amount of complaints can be
a positive indicator
vi. Entrepreneurs can easily evaluate the performance of the
organization based on the items considered important for the
success of the business
vii. Consider the frequency of ratio analysis when interpreting results
1. The frequency at shorter intervals can produce insights into
the business
2. Develop charts using shorter intervals so patterns and
deviations can be observed
3. Maintain the chart to complete the analysis on a monthly
basis
a. Reveal seasonal trends
i. Results of analysis enhance ordering, staffing,
and advertising at the business
b. In addition to this, keeping an Annual chart allows
comparing the company over years as the firm
reaches maturity
viii. Measuring the performance of a business goes beyond the basic
financial ratios of the business
ix. An analysis of how well the firm pursues its strategy over a stated
period of time documents the company’s success
IM 8-3
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written consent of McGraw-Hill Education.
Chapter Eight: Financial Analysis
7. Sensitivity Analysis (text pages 154 and 155)
Learning Objective 8-6: Explain sensitivity analysis
A. Sensitivity analysis (text page 149)
i. A chart utilizing current cash flow statement, income
statement, or balance sheet to create a pro forma projection
based upon a dramatic increase in sales, a dramatic
decrease in sales, or the complication of a major change in
the business
B. The data required to complete a sensitivity analysis
i. Current cash flow statement
ii. Income statement or balance sheet
C. The projections are based on a variety of circumstances
i. Dramatic increase in sales
ii. Dramatic decrease in sales
iii. A major change in the business
D. The advantage is a visualization of how sensitive the business is to
various factors
E. The cash flow statement is used to evaluate the impact of a
dramatic increase or decrease in sales
i. Identifies what the impact is on the organization as a whole if
the firm experiences a sudden 50 percent increase or
decrease in sales
1. If the result is an increase, the outcome to consider
is how much staff is needed to accommodate the
sales
2. Another consideration is the impact on travel or
insurance
F. Steps used in evaluation
i. List the projected cash flow statement for the firm
ii. Provide another cash flow statement that indicates a 50
percent increase
iii. Provide another cash flow statement that indicates a 50
percent decrease in sales
G. A firm that experiences a rapid increase in sales could be hurt
during the first two years of operation
i. The business could experience a recovery period in the third
year
1. Result of this analysis indicates a need for additional
funding
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written consent of McGraw-Hill Education.
Chapter Eight: Financial Analysis
2. It is very important for a business owner to gain
experience in order to diversify plans to accommodate
and handle a variety of changes in the business
ii. Projections missed by a significant amount predict that the
future of the business is not good
H. Sensitivity analysis provides advantages to the business person
i. Sensitivity analysis provides the opportunity to test
assumptions
ii. The businessperson views the potential impact of these
assumptions prior to committing additional resources
8. Use of Short Surveys in Business (text pages 155 and 158)
Learning objective 8–7:Describe the use of short surveys in business
A. Surveys are the fourth method used by a businessperson to analyze the
business
i. Surveys are a nonfinancial method of analysis
1. By comparison, Ratio analysis, deviation analysis, and
sensitivity analysis focus on the financial data associated
with the business
ii. Surveys are used to evaluate the contextual information that is not
easily categorized or interpreted by the business owner
1. Customers
2. Suppliers
3. Employees
iii. Surveys are used to gather data to enhance the financial success
of a business
iv. Random sampling is an effective measure of a large customer base
1. Survey every third customer
a. The subset of total customers reflect all customers
taking into consideration a small margin of error
v. Data obtained in a survey contains bias
1. Use judgment to interpret the results of survey
vi. Survey questions are designed to answer direct questions related
to the organization’s mission and strategy
vii. Questions in the survey are designed to provide specific data about
an organizations goals or objectives
viii. Results of survey data and interpretation
1. Data in the survey is tabulated and examined with statistical
techniques, such as percentages
2. Increase the level of sophistication of data contained in a
survey in order to learn more from the data
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written consent of McGraw-Hill Education.
Chapter Eight: Financial Analysis
3. Strategic implementation of key competitive advantage to
reveal trouble in goals or objectives of the business
4. Cross tabulation of related items and simple regressions
form a visualization of the organization beyond its
competitors
a. Cross tabulations and simple regressions are
available in most spreadsheet or software packages
b. Cross tabulation displays the distribution of two or
more variables in columns
i. For example, how the drinks match entrees in a
restaurant
c. Regression analysis is a more complex analysis
i. Reveals how different variables explain the
impact of a given measure (i.e. profits)
difference in the measurement of profits
9. Importance of Having a Measurement Focus (text pages 158 and 159)
Learning Objective 8-8: Analyze the importance of having a measurement focus
A. Use a simplistic approach to measure the standard components
of the business
B. Assure that the performance of the firm is equivalent to other
firms in the industry
C. Do not analyze areas that do not create value to the business
D. Focus efforts on areas of the firm that enhance organizational
efficiency
E. Focus efforts on areas that provide a competitive advantage to
the firm
F. Concentrate analysis efforts on the areas that are extraordinary
efforts to create differentiation in the business
9. For Review (text page 154)
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