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L I B R A R Y
Michigan State
University

ROOM USE ONLY

ABSTRACT

INDICATOR RATIOS FOR
FOREST PRODUCTS INDUSTRIES

by Robert C. Fitzgerald

For several years most facets of the American business community
have utilized financial ratio analysis as a managerial tool. Even
within the forest products industries the larger concerns became
acquainted with ratio analysis long ago. Within many of the smaller
forest products businesses though, the owners or operators often feel
that they cannot use the same type of analysis as the larger corporations.

It is the contention of this thesis that ratio analysis is
applicable to every type of forest products business, regardless of
size. A method is presented whereby any operator of a small forest products
business can evaluate his organization using ratios or proportions.
Twenty-one applicable ratios are discussed and averages given for a
sample taken from members of the Michigan Forest Products Cooperative,
Inc. An extensive example of the application of this type of analysis

to a specific company is also develOped.

INDICATOR RATIOS FOR

FOREST PRODUCTS INDUSTRIES
by

Robert C. Fitderald

A THESIS

Submitted to
Michigan State University
in partial fulfillment of the requirements
for the degree of

MASTER OF SCIENCE

Department of Forest Products

1965

r)

ACKNOWLEDGEMENTS

The author wishes to express his gratitude for the advice
and assistance given by Dr. A. B. Wylie of the Department of
Forest Products, Dr. Frank H. Mossman of the Department of
Marketing and Transportation Administration, and Dr. H. E. Larzelere
of the Department of Agricultural Economics at Michigan State
University, by Elroy Richardson and William Strohschein of the
Michigan Forest Products COOperative, Inc., and by the owners
and managers of the c00perating businesses whose financial reports

were submitted for analysis.

TABLE OF CONTENTS

ACKNOWLEDGEMENTS . . . . . . . . . . . . . .

LI ST OF TABLES O O O O O O O O O O I O O O 0

LIST OF FIGURES . . . . . . . . . . . . . .

INTRODUCTION 0 O O O O O O O O O 0 O O O O 0

Historical Background. . . . . . . . .
Scope and Applicability . . . . . . . .

APPLICATION O O O O O O O O O O O O O O O O

The Sales Dollar . . . . . . . . . . .
Expense Breakdown Ratios . . . . . . .
Other Important Ratios Involving Sales
Capital Ratios . . . . . . . . . . . .
Supplementary Ratios . . . . . . . . .

AN EXAMPLE COMPANY O O O O O O O O O O O O O

LIMITATIONS O O O O O O O O O O O O O O O 0

CONCLUSIONS AND RECOMMENDATIONS . . . . . .

ASELECTED BIBLIOGRAPHY . . . . . . . . . .

28

3O

LIST OF TABLES

The Sales Dollar . . . .

Average Expense Breakdown Ratios of Members of MFPC

Averages of Other Important Sales Ratios of Members

Of MFPC O O O O O O 0

Average Capital Ratios of Members of MFPC

Average Supplementary Ratios of Members of MFPC

Company X's Ratios - 1963

Page

10
13
16

21

LIST OF FIGURES

Figure Page
1. Operating Statement - Company X . . . . . . . . . . . . 19
2. Balance Sheet - Company X . . . . . . . . . . . . . . . 20

INTRODUCTION

Historical Background

 

Prior to the turn of the century financial statements were used
primarily to portray the worth and profitability of an organization.
Little, if any, use was made of the information contained therein in
the everyday management of the business activities.

In the early 1920's a group of consultants (Robert Morris
Associates) first conceived the idea that ratios or proportions
could be developed from various items found in financial statements
and used as tools for management. The pioneering work in this field
was done by Alexander Wall (then Secretary-Treasurer of Robert Morris
Associates) and R. W. Duning, and presented in their book entitled
"Ratio Analysis of Financial Statements".

Since that time much and varied work has been done on the
general use of ratio analysis and the Specific application of it to
various industries and business concerns. Trade and cooperative
associations have found it useful as a comparative tool, and it has
been widely promoted within retail, wholesale, and manufacturing
operations, both large and small.

The most recent work of a detailed nature on ratio analysis
per se is that done by Spencer A. Tucker and presented in his text
book entitled "Successful Managerial Control by Ratio-Analysis".

In this work he gives very detailed discussions of some #29 specific
ratios which can be developed from financial information and which have

1

2

found application under various circumstances.

Scope and Applicability

 

It is the purpose of this thesis to present a method whereby
any owner or Operator of a small forest products business can evaluate
his organization using comparative ratio analysis. The owners or
operators of these firms far too often feel that, since their operations
are relatively small and lack men with a high degree of specialized
training, they cannot use the same type of beneficial financial planning
and analysis that is used in "big business". This is usually not a
valid belief. These businessmen have both the potential capability
and the available information to enable them to use the same general
techniques used by the financial analysts of the largest corporations;
SPeeifically, ratio analysis.

Ratios are simple computations expressing the relationships
that exist between sets of figures. The various ratios which are
discussed here have been chosen because of their applicability to the
smaller forest products industries and are useful in locating present
and potential trouble areas within the organization, in testing
decisions in advance, and in suggesting ways of remedying negative
conditions.

In most instances the calculation of individual ratios for a
given company is of little use without some standard or basis for
comparison. If there are no applicable synthetic standards or rules
of thumb, the first comparison to make is with past ratios of the same
company. Trends, or stability, within ratios, over time, are very
useful in analyzing and interpreting policies and decisions. This

would include annual comparisons over the years plus shorter period

3

comparisons of a few selected ratios subject to seasonal variations.
Within the forest products industries, the ratios which include
inventory or accounts receivable are particularly sensitive, and
should be analyzed more often than once a year.

A second comparison, which is emphasized here, is one which
compares individual company ratios to current industry averages.
Each year Dun 8 Bradstreet publishes a pamphlet of "Fourteen Important
Ratios" for a number of different retailing, wholesaling, and manufac-
turing industries. Included in these industries are lumber yards,
lumber and building materials wholesalers, furniture manufacturers,
millwork manufacturers, lumber manufacturers, and paper manufacturers.
The ratios, developed from samples within these lines, are applicable
to the larger forest products industries throughout the United States.
Single c0pies of this yearly publication may be obtained, free of
charge, by writing to the Business Publications Division, Dun 8
Bradstreet, Box 803 Church Street Station, New York, New York 10008.

In order to provide an average or standard for comparison
within the smaller forest products industries, particularly in Michigan,
twelve members of the Michigan Forest Products Cooperative, Inc.
submitted year end operating statements and balance sheets for 1961,
1962 and 1963. These were used to compile an average of each ratio
discussed in this paper. These twelve participants are a representative
sample of the smaller forest products industries of the state. They
ranged in size from the largest, having net sales in 1963 in excess of
$500,000, with a total net worth of more than $150,000, to the smallest,
having net sales of a little more than $35,000, with a net worth of

approximately $3,400. They were located throughout the entire Lower

u
Peninsula of Michigan, without any tendency to group in a particular
section. All derived the major portion of their sales from wooden
pallets and boxes, with half of them also engaging in the manufacture
of grade hardwood lumber.

An attempt was made to secure data from small forest products
industries of the state that were concerned solely with the manufacture
of lumber. However, time limitations precluded the accumulation of
sufficient information on which to base new standards or determine
the applicability of the averages given here or those presented by
Dun 8 Bradstreet. Preliminary results indicate that the Dun 8 Bradstreet
ratios for lumber manufacturing are probably more applicable for
strictly sawmill operations, even the small ones.

It should be noted that the averages, as revealed by this study,
do not possess any virtue, simply because they 233 averages. What
matters is the variation from the average itself. In order to make
a thorough analysis of a business, a study would need to be made of the
trend of the various ratios and their deviations from the averages,
and then a determination made of the underlying reasons for these
variations. This, then, would expose the areas and magnitudes of

existing problems.

APPLICATION

The Sales Dollar

 

The first three ratios are a percentage breakdown of the total

sales dollar. They represent that amount of the sales dollar that is

used to purchase raw material, meet Operating expenses, and provide

the net income or profit from operations. Table 1 represents the

average percentage breakdown of the sales dollar of members of MFPC

in 1961, 1962 and 1963.

TABLE 1.--The sales dollar.

 

 

1961 1962 1963

 

 

 

Ratio High Ave. Low High Ave. Low High Ave. Low

 

Cost of goods sold H2.3 32.5 27.2 NS.6 35.8 30.3 u3.7 37.2 32.0
Operating expenses 70.3 63.5 50.9 69.9 59.u u9.3 65.8 57.5 39.2
Net profit 6.8 4.0 0.1 9.1 ”.8 -2.7 17.1 5.3 -u.u

 

The first of these ratios is the cost of goods sold to sales.
This ratio indicates that amount of the sales dollar that is used in
the purchase of raw material. It is derived by taking the cost of
goods sold figure (actual cost of material f.o.b. the company plant) in
the current income statement and dividing this by the total sales for
the same period. (The result is multiplied by 100 to convert it to a
percentage). The trend of the average cost of goods sold ratio is up
from 32.5 in 1961 to 37.2 in 1963, as indicated in Table 1. This trend

5

 

 

6
would seem to indicate that the cost of raw material is rising faster
than the price of the finished product. This might indicate a need to
look at pricing or purchasing policies.

The second sales ratio is that of total expenses to sales.

This ratio is derived by taking the total expense figure from the
operating statement and dividing it by the total sales for the same
period. It indicates that portion of the sales dollar used in meeting
all operating expenses of a business. It actually depicts the efficiency
of an organization more accurately than the net income ratio which will
be discussed next. Expenses, if low relative to the volume of business
performed, indicate efficient management practices regardless of

whether net income is high or low. The trend of the average expense
ratio is down from 63.5 in 1961 to 57.5 in 1963, as indicated in Table 1.
This reduction more than compensates for the increase in cost of raw
materials. This lower expense ratio would seem to indicate an im-
provement in efficiency over the past year.

The final sales ratio is that of net income to sales. It is
derived by dividing the total net income by the total sales for the
same period. It simply represents that portion of the sales dollar
which remains after all expenses are deducted. It is, perhaps, the
most important measure of success. The trend of the average net income
ratio is up from u.o in 1961 to 5.3 in 1963, as indicated in Table 1.
This rise is exactly equal to that reduction of Operating expenses not
used up in the rise of raw material cost. However, it should be stated
at this point that there was a tendency within the single owner firms
studied to include a portion of the owner's salary in the net income,

resulting in some slight overstatement of the net income ratio for

the business.

Although net profits are the economic end of a business, it
cannot Operate solely for the maximum of immediate profits, and
ignore long range effects. It is necessary to keep all the prOpor-
tions of the balance sheet in a healthy relationship, one to another,

while at the same time attempting to raise the net profit ratio.

Expense Breakdown Ratios

 

For the purposes of this paper, the total expense section of
the operating statement has been broken down into six sub-parts.
These are labor, depreciation, repairs, gas and oil, insurance, and
other expenses. This breakdown is meant to portray the most common
important expense items. In a given operation, however, there may
be other expenses that are as important or more important than the
ones given here. In this case, these expenses should also be studied
in the same manner as the aforementioned six.

The derivation of each of the expense ratios is the same.

They are gained by dividing the given expense by the total sales for

the same period. Again, the resulting figure represents that prOpor-
tion of the sales dollar used in meeting that particular expense.

The sum of all expense ratios should be the same as the ratio of

total expenses to sales. The average expense ratios, of the COOperative
members studied, for 1961, 1962, and 1963 are given in Table 2.

A brief description of each average expense ratio is provided.
The labor cost ratio, while influenced to some extent by the wage
level, is not entirely related to it, but indicates more specifically
the effectiveness of management in the use of labor. If the trend of

this ratio is downward, the company is in good shape. If it is rising,

8

it may be caused by several factors, but most likely it is indicative

of reduced efficiency in the labor force. If the trend is erratic,
as in the case of the averages, interpretation becomes a little more

difficult.

TABLE 2.--Average expense breakdown ratios of members of MFPC.

 

 

 

 

 

Expense Ratio High Ave. Low High Ave. Low High Ave.

 

Labor 43.4 36.2 29.3 41.1 33.8 24.5 41.6 34.7
Depreciation 11.7 4.4 1.7 8.2 4.9 2.5 6.6 4.0
Repairs 7.0 3.2 0.3 5.1 2.7 1.0 6.4 2.7
Gas and oil 10.8 3.9 0.7 11.5 4.8 1.2 10.4 3.9
Insurance 3.7 2.2 1.7 8.1 3.2 1.3 3.4 2.0
Other .21.1 13.6 8.7 12.6 10.0 3.1 15.9 10.2

 

The depreciation ratio is a little more difficult to interpret,
since it reflects policies, such as replacement policy, which may vary
between firms.' A relatively low ratio might indicate trouble in the
days ahead due to high repair bills and down time, since it would seem
that equipment would be getting old. A relatively high ratio might
indicate an over-extension into equipment purchases, tying up valuable
working capital.

The trend of the average repairs to sales ratio is down and this
is good. A rising ratio would indicate the need for a closer look at
replacement policy and preventative maintenance policies. This ratio
should be analyzed in conjunction with the previous one in order to
give a clearer picture of the adequacy of a given replacement policy.
There should be a semblance of balance between these two ratios. For

example, if the depreciation ratio rises along with the repairs ratio,

9

this should call attention to the fact that, in all probability,
investments in fixed assets can be improved. Conversely, a rise
in the depreciation ratio, accompanied by a decrease in the repairs
ratio, should confirm a belief that wise replacement investments
are being made.

A relationship also exists between the labor and depreciation
ratios. Automation and mechanization are regarded as prOgressive

moves by a majority of the firms in the forest products industries.
A trend toward automation and mechanization should be reflected by
a rising depreciation ratio (and probably repairs ratio also), but
unless the labor ratio declines by a compensating amount little
justification for increased equipment expenditures can be found.

The gas and oil, insurance and other expense ratios will not
be discussed here since they should be self explanatory. An attempt
should be made to establish a downward trend in all expense ratios,

since this indicates efficiency in cost relative to the volume of

business done.

Other Important Ratios Involving Sales

 

There are four other important ratios which involve sales,
this time as the numerator of the fraction. They are sales to
accounts receivable, sales to inventory, sales to fixed assets, and
sales to net worth. The averages for these ratios are given in
Table 3.

The sales to accounts receivable ratio is simply an indicator
of the status of the credit business. It is gained by dividing net

annual sales by the total of trade accounts and bills receivable at

the end of the accounting period. The larger sales are in comparison

10
to receivables, the more nearly a complete collection for the period
has been approached and the greater the probable liquidity of the
receivables. Conversely, the lower this ratio, the greater the
probability of the presence of poor collection methods and stale
receivables. Table 3 shows that there is a steady, and rather large,
downward trend to this ratio. This would be a favorable indication

that the status of extended credit is improving.

TABLE 3.-—Averages of other important sales ratios of members of MFPC.

 

 

 

 

 

 

1961 1962 1963
Ratio High Ave. Low High Ave. Low High Ave. Low
Sales to:
Acc'ts. Receiv. 120.4 37.0 13.6 135.2 35.1 8.8 54.5 24.3 9.7
Inventory 71.4 23.9 11.3 56.7 19.3 5.2 158.1 41.0 7.4
Fixed Assets 11.1 5.3 2.1 11.3 5.2 1.4 74.5 12.7 2.9
Net Worth 4.9 3.7 2.0 5.3 3.9 2.2 8.6 5.9 3.5

In conjunction with the sales to accounts receivable ratio,
there is one other analysis of business transactions which can be
used to indicate the comparative effectiveness of collections, and
should be used whenever the status of extended credit appears to be
deteriorating. That analysis gives the guide known as "the average
collection period based upon sales".1 It is obtained by dividing the
annual net sales by 365 days to obtain the average sales per day, and
then dividing that result into the combined sum of accounts and notes

receivable plus any assigned accounts and discounted notes. To be in

 

1Roy A. Foulke, Behind the Scenes of Business (Dun 8 Bradstreet,

 

1952)

11
healthy shape, "the average collection period should be no more than
one-third greater than the net selling terms."l With selling terms,
for example, of two percent discount in ten days, net 30 days, the
average collection period should not exceed 40 days.

The sales to inventory ratio is gained by dividing net annual
sales by total inventory. This ratio expresses the proportion between
sales and inventory which, while not a definite physical turnover
indicator, is a comparable measure of turnover from year to year.
Marketing effectiveness can be measured, within reasonable bounds, by
the sales developed per unit of inventory. The higher the relationship
of sales to inventory, the greater is the merchandising capacity and
the more probable the freshness, saleability, and liquidating value of
the inventory.

The sales to inventory ratio is one of the more erratic ratios

which must be considered. Some, and Often a great deal, of variation
is normal in this ratio, depending on the time of year it is computed,
geographic location, and similar interrelated factors which differ
between concerns. It is for this reason that, when comparing a given
ratio for an individual firm to the average, considerable differences
may exist which are not always indicative of poor management policies.
Within the firms studied, inventories were almost entirely made up of
raw material and in-process goods, and were valued at cost in each
instance. If inventories vary a great deal in kind, Or if methods of
valuation differ, a comparison with the average ratio would not be too
meaningful. It would probably be more beneficial to compare the

company's own ratios through the years, as they are computed under

 

1Roy A. Foulke, Behind the Scenes of Business (Dun 8 Bradstreet,

1952)

12
essentially the same set of circumstances.

The sales to fixed assets ratio is especially useful for new
businesses or those considering expansion. This ratio is derived by
dividing the net annual sales by the total amount of fixed assets. It
indicates the approximate volume of business that is needed to warrant
a given amount of investment in fixed assets. When this ratio is
relatively low, it usually means that too great an investment in fixed
assets has been made relative to the volume of business for which they
are used. If this ratio is high, further analysis would be warranted
to determine whether such a ratio resulted from extreme efficiency in
the use of fixed assets, or from a policy of letting the fixed assets
depreciate without any attempt to rebuild, repair, or keep them in
satisfactory condition to provide adequate facilities for doing a good
job. It should be further recognized that an organization leasing or
renting a large portion of its fixed assets will have a comparatively
high figure for this ratio; however, the operating expense ratio would
be correspondingly higher since it would reflect rent payments. In
many cases careful consideration is given to the purchase or building
of facilities solely from the viewpoint of cost and ease of financing.
There may not be a sufficient volume of business to warrant a given
amount of investment in fixed assets at a given location. Under normal
conditions, a rising fixed assets ratio should be established prior to
new investment into additional fixed assets.

The sales to net worth ratio reflects the sales activity of
invested capital. It is gained by dividing net annual sales by true
net worth (total assets minus total liabilities); Capital is invested

in any enterprise in the hope of a substantial return. The probability

13
of such a return is largely dependent upon a reasonable activity
of the investment. The proportion borne by sales to net worth
establishes a measure of this activity. When the relation of sales
to net worth is an increasing one from year to year, it can be

reasonably assumed that the invested funds are more actively, and

probably more profitably, employed than they could be elsewhere.

Capital Ratios

 

The next series of important ratios have been termed capital
ratios. They are the current ratio, the acid test, inventory to
receivables, and net worth to liabilities. The averages are given in

Table 4.

TABLE 4.--Average capital ratios of members of MFPC.

 

 

 

 

 

1961 1962 1963
+—
Ratio High Ave. Low High Ave. Low High Ave. Low
Current Ratio 4.8 2.5 1.2 8.2 3.2 1.5 9.1 3.6 1.3
Acid Test 1.1 0.8 0.6 4.3 1.4 0.5 6.7 2.0 0.4
Inven./Receivables 5.9 2.3 1.0 3.6 2.1 0.6 2.7 1.2 0.1
Net Worth/Liabil. 7.1 4.0 0.9 6.7 3.0 0.3 7.1 2.7 0.4

 

The current ratio indicates the dollars of current assets on
hand to offset the dollars of current debt. It is gained by dividing

total current assets by total current liabilities. The higher this

ratio runs, the freer current assets are from debt claim by creditors,

and the more likely it is that creditors would receive prompt and

complete payment on demand. An established guide used in many circles

is that this ratio should not be less than 2.0.

14

Although the average current ratio of the firms studied has
not been below 2.0, and in fact has risen to a comfortable level of
3.6, this should not be taken as an infallible indication of a very
strong current credit position. If the total of cash and receivables
is less than the total of current liabilities, then considerable doubt
is thrown on the current credit strength regardless of what the current
ratio happens to be.

In its briefest form the "acid test" consists of measuring the
total of cash and receivables against total current liabilities. To
meet the test satisfactorily, this ratio must be equal to or greater
than 1.0. If this acid test is applied and a company meets the test,
then its current liabilities will not exceed the total of cash and
receivables. The whole value, then, of the inventory, whatever it
may finally check out to be, becomes available as a buffer against
loss.

As was mentioned in the discussion of the current ratio, if
the acid test ratio is less than 1.0 then considerable doubt is
thrown on the current credit strength regardless of how high the
current ratio happens to be. In the case of the averages, however,
the trend of this ratio has been upward, and when coupled with the
current ratio would seem to indicate a favorable position as far as
the ability to secure short term credit is concerned.

The inventory to receivables ratio expresses the relationship
between inventory, a cost item, and receivables, a selling price
item, which together usually form the predominating factor in the
total of current assets. It is derived by dividing inventory by

the trade accounts receivable. The fluctuations of this ratio in a

15
measure check the fluctuations of the current ratio, due to the fact
that sale of merchandise and transformation of inventory into
receivables adds the equivalent of gross profit on the sale to the
asset side of the current ratio without any necessary addition to the
liability side. It can also be used to indicate the preponderance of

either merchandise or receivables in the current assets which makes a

considerable analytical difference in estimating probable losses or
profits due to inventory fluctuations in different phases of the business
cycle. For most firms, it is desirable to keep this ratio as low as
possible.

The net worth to liabilities ratio expresses the prOportion
existing between the capital owned by an organization and the capital
loaned to it by creditors. It is derived by dividing the true net
worth by the total liabilities, including both current and long term.
The whole capital at use in supporting the operation of a company
consists of net worth and that capital loaned to it more or less
temporarily by creditors, represented by debts. The proportion
existing between owned capital and that borrowed measures and records
debt pressure. The higher this ratio, the lighter the debt pressure
and the further removed a company is from the criticism of being
"topheavy with debt". There has been a sizeable decline in the average
ratio since 1961 and, although 2.7 is not considered by many concerns
to be "too low", a close watch should be kept on this ratio in order

to impede or stop this decline.

Supplementary Ratios

 

There are four other ratios which are necessary for a complete

analysis of the foundation of any forest products business. These are

16
net worth to fixed assets, funded debt to fixed assets, working
capital to inventory and net income to net worth. The averages

are given in Table 5.

TABLE 5.--Average supplementary ratios of members of MFPC.

 

 

 

 

 

 

1961 1962 1963
Ratio High Ave. Low High Ave. Low High Ave. Low
Net Worth/Fix. Ass. 1.4 1.1 0.6 1.3 1.1 0.4 1.7 1.0 0.4
Fund. Debt/Fix. Ass. 51% 15% 10% 89% 32% 0% 87% 32% 0%
Working Cap./Inven. 1.1 0.8 0.3 1.9 1.1 0.5 5.7 2.1 0.3
Net Income/Net Worth 21% 11% 10% 28% 14% 6% 40% 2 % 3%

 

The net worth to fixed assets ratio expresses the proportion
between owned capital and the money not currently invested in fixed
assets. It is gained by dividing true net worth by net fixed assets.
Plant or other fixed assets should be financed primarily from owned
capital by the ordinary forest products industry. The higher this
ratio is, the more liquid is the net worth of a company and consequently
the more effective it is as a liquidating protection to creditors.

The funded debt to fixed assets ratio is gained by dividing long
term liabilities by fixed assets. It measures the extent to which fixed
assets are mortgaged. It is useful in determining future possible
borrowing power through mortgages. When the proportion of funded debt
to fixed assets rises abnormally high, there is danger of debt becoming
a residuary claim on current assets. The condition of a company having
a thin current ratio but a large asset item of effective plant or
real estate with no funded debt is quite different from one with both

a thin current ratio and a high proportion of mortgages against fixed

l7
assets. Fixed assets can be used as a good secondary defense against
a low current ratio position by the amount of their liquidating
realizable value.

The average ratio is presently at 32 percent. However, this
ratio should be studied with the net worth to fixed assets ratio.

In looking at these average ratios tOgether it can be seen that although
32 percent of the fixed assets are presently under mortgage, net worth
(or owned capital) will exactly offset the amount invested in fixed
assets. This leaves the entire current assets as a buffer against

loss of payment on long term debt.

The working capital to inventory ratio is the difference
between current assets and current liabilities divided by inventory.
This ratio measures the percentage of working capital that depends
on inventory as a liquidating element. With the 1963 average at 2.1,
this would indicate that less than half the working capital is tied up
in inventory. It is desirable to keep this ratio as high as possible
in light of inventory policies.

The net income to net worth ratio measures the percentage
return on investment. The amount invested in a company, commonly
known as capital or net worth, is entitled to a reasonable return.
This reasonable return or prospect for such a return is what attracts
capital to any enterprise. Again, it is the percentage relationship
that profits bear to net worth, rather than the dollar amounts, which'
measure return. With the trend of the average ratio upward, and with
the 1963 average at an almost unbelievable 23 percent, the forest
products industry, as represented by members of the cooperative,
would appear to be in a strong position to attract additional capital

so vitally needed for expansion and improvement.

AN EXAMPLE COMPANY

In order to more concretely demonstrate the use of financial
and operating ratios within the smaller forest products industries,
an example is included here. This company is actively engaged in
operations in Michigan at the present time; however, the name has
been changed to conceal its true identity.

Figure l portrays the end of year operating statement of
Company X for 1963, and Figure 2 the balance sheet compiled at the
same time. The figures found on these two statements were used to
compute Company X's ratios, shown in Table 6.

Now assume that the owner or operator of Company X has been
provided with this current set of ratios (Table 6) along with the
averages given in Part II. Using this data he can proceed to make a
critical analysis of the financial and operating conditions of the company.

First, a look at the three major subdivisions of the sales
dollars. Out of every dollar of sales generated, 39.1 cents goes to
pay for raw materials. It is noted that this figure is about 2 cents
on the dollar higher than the average. Why? Is raw material more
expensive here than elsewhere? Is this lower quality stock thus
producing less usable material, while costing the same as the stock
others are using? Are operations inefficient in the use of material
and perhaps even wasteful? These questions are the ones which must
be answered. Then actions must be initiated which will correct the

undesirable situation and thereby reduce this ratio.

18

l9

 

Sales (less discounts) $ 365,325
Opening Inventory 51,431
Purchases (+) 140,516
191,947
Closing Inventory (-) 49,218
Cost of Goods Sold (-)$ 142,729
Gross Margin $ 222,596

Operating Expenses:

Labor 113,308

Depreciation (+) 17,150

Repairs (+) 6,468

Gas and Oil (+) 5,232

Insurance (+) 6,814

Other (+) 57,051
Total Expenses (-)$ 206,023
Net Income (Profit) 5 S 16,573

 

Figure l.--Operating Statement - Company X

20

 

ASSETS
Current Assets:
Cash 1,000
Accounts Receivable 18,287
Inventory 49,219
TOTAL
Fixed Assets (Net):
Land 35,568
Buildings 24,448
Equipment 48,896
Furniture 8 Fixtures 12,224
TOTAL
TOTAL ASSETS
LIABILITIES

Current Liabilities:
Notes Payable
Accounts Payable

TOTAL

Fixed Liabilities (Long Term):

Mortgages 1
TOTAL

TOTAL LIABILITIES

NET WORTH (Assets - Liabilities)

8,726

26,179

06,159

6 68,506

$ 122,236

$ 190,742

$ 34,905

6 106,159
$ 141,064

$ 49,678

 

Figure 2.--Balance Sheet - Company X

21

TABLE 6.--Company X's ratios - 1963.

 

 

The Sales Dollar:

1.
2.
3.

Expense

4.
5.
6.
7.
8.
9.

Cost of goods sold to sales
Operating expenses to sales
Net income to sales

Breakdown Ratios:

Labor to sales
Depreciation to sales
Repairs to sales

Gas and oil to sales
Insurance to sales
Other expenses to sales

Other Ratios Involving Sales:

10.
11.
12.
13.

Capital

14.
15.
16.
17.

Sales to accounts receivable
Sales to inventory

Sales to fixed assets

Sales to net worth

Ratios:

Current ratio

Acid test

Inventory to accounts receivable
Net worth to liabilities

Supplementary Ratios:

18.
19.
20.
21.

Net worth to fixed assets
Funded debt to fixed assets
Working capital to inventory
Net income to net worth

 

22

Next it is noted that 56.4 cents out of every sales dollar is
used to meet Operating expenses. This is slightly lower than the
average, and therefore the company is probably doing all right in
this area. But, to be on the safe side, a look should be taken at each
expense ratio separately.

This now leaves 4-1/2 cents out of each sales dollar as profit.
It would be desirable to raise this figure, particularly since it is
lower than the average by almost a penny on the dollar. This can be
accomplished by solving the problem of a high materials expense or
by even lowering one of the operating expenses, which will be looked
at now.

Looking at the labor ratio, it is seen that this figure Of
31 cents on the dollar is quite a bit lower than the average of
almost 35. This should be adequate evidence that the company is getting
its money's worth for the investment in labor. It is noted that the
depreciation ratio is running a little high but appears to be offset
by a very low repairs ratio, so this indicates little need of attention
in this area. The same is true of the gas and Oil and insurance
ratios - they are alightly less than average and appear to warrant
little effort at reduction.

However, a look at the other expenses ratio which shows that it
contains 15.6 cents of every sales dollar, should provide incentive
to try and break this account down still further because there is
probably an excessive expense buried here that could be reduced if it
were located.

A couple of minor trouble spots have already been found in

direct expenditures - cost and use of raw material and an excessive

23

amount of "other expenses". What about the more intangible portions
of the sales relationships?

Looking at the sales to accounts receivable ratio, it is found
that this 20.0 is slightly less than the average of 24.3, but it is
also noted that there is a pretty wide spread in this ratio, from a
high of 54.5 all the way down to 9.7. It should not be felt that this
level must be maintained or improved. This can only be done by keeping
collections current.

The sales to inventory ratio points out a startling fact - only
$7.40 in sales was generated for every dollar carried in inventory.
This is far below the average of $41.00 of sales per dollar of inventory.
It should be realized of course that there is a great deal of variation
in this ratio among firms but still the question must persist - is too
large an inventory being carried, thus tying up valuable working capital
plus risking loss if inventory devalues with time? It is decided to
defer answering this question until a further look has been taken into
the other ratios.

Focusing attention next on the sales to fixed assets ratio, it
is again noted that 3.0 is substantially below the average of 12.7.
Normally, this would indicate an over-investment in fixed assets relative
to the volume of business done. In other words, there is probably an
excess plant capacity which is not being used and sales should be
increased, and therefore production, or investments in fixed assets
should be cut back. Looking again at the low sales to inventory ratio,
though, another thought would come to mind - perhaps the company, in

fact, is over-invested in fixed assets which are being utilized to

24
their fullest, thereby producing an over supply of goods relative to
sales. This could certainly be the answer to the large inventory, if
it is composed primarily of finished goods, and is a point well worth
further investigation.

The sales to net worth ratio is 7.4 compared to an average
of 5.9. This data provides reasonable assurance that invested capital
is active and should provide a desirable return.

Two more possible trouble spots have now been located - an
apparently excessive inventory and perhaps an over investment in fixed
assets. Now a look should be taken at the capital situation.

First the current ratio is 2.0. Many credit managers and
analysts use this exact figure as a minimum guide line when investi-
gating a company's credit position. However, it is noted that the
average is 3.6 and it should be re-emphasized that a very large
inventory is being carried. These two facts indicate that maybe the
current credit position is not quite as safe as might be thought at
first.

The acid test ratio of 0.6 bears out the fact that inventory
makes up a large portion of current assets and that cash and
receivables alone are not enough to cover current liabilities. This
emphasizes the doubts that exist about the current credit position and
discredits the current ratio, even though it is at 2.0.

The next ratio, that of inventory to accounts receivable, is
another confirmation of the belief that too much inventory is being
carried. With inventory being 2.7 times as large as receivables, it
is by far the largest part of current assets. This is not particularly

desirable since inventory is subject to devaluation with a downward flux

25
in the market, and since, in most states, inventory is subject to
various taxes.

Looking next at the net worth to liabilities ratio, it is found
that the company really is in a very poor debt position. This ratio
is 0.4. The average is 2.7, and even this would be considered by some
to be a fairly low ratio. Serious thought needs to be given to post-
poning any new purchases or expansion plans until some of the burden
of this heavy debt pressure is removed.

In order to fully complete the analysis, the last four
supplementary ratios must be studied. Again, the company is found to
be in a poor position when net worth to fixed assets ratio is examined.
With this ratio being only 0.4 it would be difficult to liquidate a
substantial portion of net worth, if the need should arise.

The funded debt to fixed assets ratio measures the amount of
fixed assets which are mortgaged, in this case 87 percent. This
should be just one more pointed reminder that the company's credit
position seems to have been o‘er-extended, particularly in long term
mortgages. In fact, the interest charges that are being payed on all
this borrdwed capital will account for over 10 percent of "other expenses".

A final ratio to emphasize the severity of the credit position
is the working capital to inventory ratio. With this ratio at 0.7 it
can be seen that besides having all working capital tied up in inventory,
there is some borrowed money in inventory too. This goes back to the
probIem of an excessive inventory stock.

The last ratio to look at is perhaps the one holding the most
interest, since it measures the return on invested capital. The net
income to net worth ratio is only at three percent, but this is really

not too surprising since the only way to improve it is to eliminate or

26
reduce the problems already discovered.

As a summary of this ratio analysis, a list can now be made
of the major problem areas discovered, and an attempt made to find
solutions to them in light of company policies.

1. Excessive inventory

2. Over investment in fixed assets

3. Over extension of credit - both short and long term

4. Relative cost of raw material

5. Excessive amount of "other operating expenses", which

should prompt the search for an individual expense
account which appears to be out of line

No attempt will be made in this example to provide possible
solutions to the problems. The alternatives available are many and

must be evaluated in the light of company policies and objectives.

LIMITATIONS

Whenever an analysis of this type is being planned the
question will always arise as to what ratios are significant.
There are a vast number of ratios which can be developed just
from the items listed on the balance sheet and the income
statement. The twenty-one which have been discussed here seem to
be the most significant for the smaller forest products businesses
taken as a group. Within a given organization, however, Special
circumstances may dictate the use of a different set of ratios
tailored to meet specific requirements. Additional ratios, which
have proven useful under various conditions, are discussed at
length in the references given at the end of this paper.

An additional limitation, of this study in particular, was
the inadequacy of many of the record keeping systems of the smaller
wood using industries. Whenever records are poorly or inaccurately
maintained the usefulness of any analysis made of them is subject to
question. Also it was found that even in the better systems certain
accounts or classifications among various firms did not contain the
same elements, thereby reducing the effectiveness of comparing

individual ratios with average ratios.

27

CONCLUSIONS AND RECOMMENDATIONS

\

Ratio analysis, as presented here, is an applicable managerial
tool which can be, and should be, utilized by the owners or operators
of all forest products industries. It is useful not only in locating
present and potential trouble areas, but also in suggesting courses of
action to take in everyday management of operations.

Emphasis in the future should be placed on the installation
and maintenance of adequate record keeping practices. In an attempt to
assist in reducing or eliminating the limitation to the use of ratio
analysis which arises from poor record keeping practices, a Forest
Products Business Record Keeping Book has been developed by the Cooper-
ative Extension Service of the Department of Forest Products at Michigan
State University. Should this record keeping system prove to be widely
accepted, it would not only improve the quality and quantity of informa-
tion available to the owners or operators, but would also provide a
standard set of records which would lend themselves more readily to
industry-wide ratio analyses, such as this one. Acceptance of this
record keeping system would also further the possibilities of economically
securing the benefits available through the group useage of electronic
data processing.

As a final conclusion, no statistical study or ratio analysis will
ever substitute for management judgement. Ratios will not provide
solutions to problems nor dictate successful operating policy. Ratios
are helpful in measuring the performance of a business and in locating

28

29
potential or present trouble areas. In addition, the knowledge of
what others in the same line are doing can be of real assistance in
making decisions. This knowledge can be gained by the use of studies,
such as this one, which yield averages for a group of comparable businesses.
Beyond this, it is up to the individual managers to initiate effective

action.

1.

7.

8.

9.

10.

ll.

12.

A SELECTED BIBLIOGRAPHY

Davison, E. H. "Use of Accounting Ratios". Accountant.
Vol. 138, April 19, 1958.

 

Financial and Operating Ratio Surveys by Trade Associations.
Symposium pfiblished by Amefican Trade’Association
Executives, 1145 19th Street, N.W., Washington, D.C.
1946.

 

Foulke, Roy A. Behind the Scenes of Business. Dun 8 Bradstreet,
Inc., New York, 1952.

 

Foulke, Roy A. Genesis of the Fourteen Important Ratios.
Dun 8 Bradstreet, Inc., NeinOrk,'1955}

 

Foulke, Roy A. Practical Financial Statement Analysis.
McGraw-Hill Book Co., Inc., New York, 1953.

Goetz, B. E. Management Planning and Control. McGraw-Hill
Book Co., Inc., New York} 1949.

 

Guides for Business Analysis and Profit Evaluation. U.S.

 

Department of Commerce, Business and Defense Services
Administration, Washington, D. C., 1949.

King, R. M. Analysis and Use of Selected Financial Ratios
as Guides to Management Policies afidFPractiEes of
Michigan Copperatives. Unpublished Ph.D.—Thesis,
Michigan State University, 1950.

 

 

Klippel, G. C., A. F. Chapman, Jackson Martindell and H. E.
Everding. Danger Signals Shown in Financial Statements.
National AssoCiation of Credit Men, New YOrk, 1951.

 

Krogstie, Walter H. "What an Industry-Wide Operating Ratio

Study Means to Management". Transcript. Vol. 18,
November, 1961.

 

Larzelere, H. E. and R. M. King. Ratios as Measuring Sticks
for Elevator and Farm Supply Organizations. ‘Special
Bulletin 380, Agricfiitural Experiment Station, Michigan

State University, 1952.

Sanzo, Richard. Ratio Analysis for Small Businesses.
Small Business AdministratiOn, Wa§hington, D. 0., 1960.

30

l3.

14.

15.

16.

17.

31

Specthrie, S. W. Basic Cost Accounting. Prentice-Hall, Inc.,
New York, 1950.

 

Tebeau, Robert L. "Retail Operating Ratios - A Tool for
Management". Journal of Retailing. New York School of
Retailing, New York, December, 1947.

 

Tucker, Spencer A. Successful Managerial Control by Ratio-
Analysis. McGraw-Hill Book Co., Inc., New York, 1961.

Wall, Alexander. Basic Financial Statement Analysis.
Harper 8 Bros., New York,’1942.

Wall, Alexander and R. W. Duning. Ratio Analysis of Financial
Statements. Harper 8 Bros., New York,’1928.

 

 

Westerdahl, William E. "Comparing the Company With Its Industry
by Ratios". N.A.A. Bulletin. Vol. 43, Sec. 1, November, 1961.

 

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