Business owners have access to an overwhelming amount of information. Your accounting software, for example, can provide hundreds of different reports. A web search may point you to dozens of financial indicators to manage your company. Every business owner needs a small set of financial tools to make informed decisions. Consider using these financial ratios to manage your business.
As you analyze ratios, consider how other companies in your industry compare. For example, startup companies that don’t generate consistent earnings (or no earnings at all) will probably raise all of their capital by issuing stock. These companies cannot borrow money easily, since they don’t generate reliable earnings to make principal and interest payments. If your business is a startup, you should look at ratios that are related to equity.
Liquidity ratios
Liquidity refers to the ability to collect enough cash inflows to operate your business each month. This is all about your company checkbook. To understand liquidity, you need to know the difference between current and noncurrent assets.
Current assets are cash- and assets that will be converted into cash- within 12 months. Two big current asset balances are accounts receivable and inventory. Most businesses collect their receivables in cash within 60-90 days. If a receivable isn’t collected after 90 days or so, the asset is reclassified as a bad debt expense.
Many companies must carry inventory. Your business also expects to sell inventory within a few months- certainly less than one year. If the inventory doesn’t sell, it may be obsolete, which means that the inventory should be expensed. Both accounts receivable and inventory are assets that should be collected in cash or expensed.
Current liabilities, on the other hand, are debts that will be paid within 12 months. In addition to your accounts payable balance, the current portion of long-term debts is considered a current liability. If your 10-year bank loan, for example, has $2,000 in principal and interest payments due within a year, the $2,000 is a current liability.
So, your liquidity game plan is to convert enough current assets into cash fast enough to pay current liabilities as they come due. Here are some financial ratios that can be helpful:
- Current ratio (Current assets / current liabilities): This ratio should always be greater than one. If so, that means that you’re staying ahead of the curve. You’re generating enough current assets to pay current liabilities.
- Quick (Asset test) ratio: (Current assets – inventory)/ (current liabilities). This ratio is the current ratio with inventory subtracted from current assets. The idea here is that inventory is the current asset that may take the longest to sell- to convert into cash. The quick ratio subtracts the inventory balance from the ratio.
Since accounts receivable and inventory are so important, there are two other ratios that you can monitor to make business decisions:
- Days receivables outstanding: [(365 days) * (Average receivables)] / (Net credit sales). This formula is more complicated, but the information it provides is useful. When you sell on credit, you give your customer an invoice and post a receivable. This formula tells you how large your receivable balance is, compared to credit sales. Your goal is to minimize your receivables (which means that you’re collecting cash quickly) while you increase credit sales. If customers pay quickly, why not sell them more on credit?
- Days payables outstanding: [(365 days) * (Average payables)] / (Purchases). The flip side is to consider your payable balance. When you buy on credit, you may receive an invoice and post a payable. This formula tells you how large your payable balance is, compared to purchases. Your goal is to use payables to manage your cash flow. If you can put off paying some bills, great- but not to the extent that you can’t pay on time and anger a vendor.
These liquidity ratios should be a top priority, because cash flow is so critical. If you can’t generate enough cash, you can’t operate your business. Consider analyzing these ratios each month.
Solvency ratios
While liquidity is all about your checkbook (the short term), solvency addresses the long-term viability of your business. Can your business survive and grow over a period of years? That’s the question that solvency ratios answer for you.
To understand solvency ratios, think about the two ways that you can raise money to run your business. Finance has become complicated, but there are only two basic choices. You can borrow money by taking out a loan or issuing a bond. In this case, the other party is a creditor. You make interest payments and repay principal at maturity.
Your other choice is to sell equity (ownership) in your business. Instead of creditors, the people who provide funding are shareholders. Your shareholders may earn a dividend or some other payout based on your profit. Most important, shareholders will have some say over important decisions that you make in your business.
Before you dive into the ratios, consider one more point. Issuing debt means that you will have a required payment schedule. You’ll have to make interest payments and repay principal on specific dates. On the other hand, when you issue equity, you may have more flexibility. The decision to pay a dividend out of your earnings may be up to you. You may choose to pay a dividend, or retain those earnings for use in the business.
Here are some useful solvency ratios:
- Debt to equity ratio: (Long-term debt) / (stockholder’s equity). This ratio looks at debt and equity as a ratio. Keep in mind that the more debt you issue, the more interest you must pay. If the numerator (debt) keeps growing in comparison with equity, it may be a red flag that you’re taking on too much debt.
- Interest coverage ratio: (Operating income before taxes and interest) / (Interest expense). You use this ratio to consider whether or not the income you generate can support your interest payments on debt. For starters, operating income refers to income you generate from your day-to-day operations, or your primary business. Taxes and interest are subtracted, because those payments are mandatory. What you have left in the numerator is the “cushion”- the amount of extra earnings you have after paying taxes and interest. The idea is to grow the numerator (income) to support the denominator (interest expense). The bigger the ratio, the better.
Use these ratios to keep tabs on your company’s solvency.
Operating a business can be a challenge. There’s so much information to consider, which makes it difficult to decide what data is useful. Use these ratios to make informed decisions about your business.