by Ted Saul, Senior Staff Writer
If a vote were taken for the most confusing and difficult sections of a business plan, the financial statements would most likely win. While the most common and required reports are the balance sheet, income statement and cash flow analysis, the financial ratios play just as important role but are easily over looked. These same calculations can be used to monitor the health of an operating company as well.
Let’s take a couple of the liquidity ratios for example. “Current” ratio is calculated by dividing current assets by current liability and answers the question, is their enough resources to pay your debt over the next twelve months. A 2 to 1 ratio is recommended but may vary dependent on the nature of the business. The higher the current ratio the more liquid the company is and able to meet short-term debt payback needs. There a few steps you can take to bring the ratio up that include paying off some of the short-term debt, increasing your current assets or converting non-current assets into current. A second ratio, the “acid test “, also known
as the quick ratio will indicate how well a business can use its “quick cash” to retire its liabilities. In other words, if your revenue suddenly stopped could you pay off your current debt almost immediately using assets easily convertible? This would be resources such as cash, government securities and accounts receivable. A one to one quick ratio is acceptable assuming the collection of your accounts receivable doesn’t lag behind your accounts payable and there is no additional risk for slowdown of incoming payments. However if a few of your customers are not liquid, the chance of them being slow or not making payments increases. Staying aware of the financial status of your customers while noting how quickly receivables are being collected will reduce this risk. If a ratio of less than one is calculated short-term liabilities will not be able to be met if the need arise. A quick ratio that is too high however may indicate that you are not operating as strong and lean as you should and not letting your resources work for you. Examining your average collection period and inventory turnover will also help ensure your liquidity is where you want it to be.
Once you understand the liquidity ratios you may want to tackle the profitability ratios that help demonstrate if your business is earning as much profit as possible. These include return on the owner’s equity, net profit on sales and return on investment. A few well written “what-if” spread sheets will also be helpful in figuring out how changes to your balance sheet will affect your status. There are also several sources that will give recommended ratios by industry; some are paid subscriptions while others are free of charge such as www.creditguru.com/ratios/inr.htm.
Ted Saul provides business consulting that assists start-up and small business with organizational and planning needs. Ted holds an MBA from Regis University out of Denver Colorado and can be reached at t.saul@juno.com, teds787 on Twitter and on LinkedIn.