Things might seem to be humming along in your business. But how are you doing, really? One of the biggest surprises to business owners is that even if you have both sales and profits, you might not have enough cash to make a planned purchase or even to pay your bills on time.
The reality is that even after you’ve successfully delivered products and services to your customers, you might not be paid on time. Little things – including delays add up silently yet quickly – then BAM! You’re out of cash. When you’re short of cash, the likelihood of making sub-optimal business decisions skyrockets. How can you prevent unpleasant surprises in your business? Financial ratios.
A few ratios can provide quick visibility into your business; financial ratios act like the canary in the coal mine. Ratios come in all shapes and sizes and can be made to be quite complex; but you don’t need to revisit the horrors of algebra class to quickly see what’s really going on in your business.
Ratios are not a panacea. Nevertheless a few common ratios, taken with some caution, provide quite a bit of information about the relative performance of your business. In particular, a careful analysis of a combination of a few of these ratios might help you to spot early warning signs that could help you avoid dreaded cash shortfalls.
Each type of financial ratio is used for a specific purpose; think of a ratio as a tool. A hammer has one purpose, while a screwdriver has another. Same concept. Ratios can be made quite complex, yet there are many simple ways to apply them.
Three fundamental types of ratios encompass most of what you’ll be working with in your business are: liquidity, activity, and profitability ratios. Let’s explore them in turn.
Liquidity ratios are a family of financial ratios that measure your ability to adequately meet your short-term obligations. The scenario is if you had to pay all your bills today, could you do it with what is on your balance sheet. Let’s look at the quick ratio:
Quick ratio = current assets – inventory
. current liabilities
Current Assets generally include cash on hand, cash in checking accounts, liquid securities, stock inventories, notes receivable due within one year, and accounts receivable.
Current Liabilities generally include current notes payable, accounts payable, payroll taxes, income taxes, interest payable, and other accrued expenses.
Greg is a structural engineer who is in an uncomfortable cash squeeze. He can’t meet his bill-paying deadlines. The quick ratio will reveal the cause.
From Greg’s balance sheet, his current assets include $17,000 in cash, $13,000 in accounts receivable, and $20,000 in stock inventories. Let’s ignore inventories for now.
Current liabilities include $28,000 in accounts payable and $4,000 in provision for taxes.
Quick ratio = 30,000
= 0.94 Target > 1.1
The quick ratio of 0.94 shows what’s causing Greg’s cash squeeze. His current liabilities exceed his liquid current assets. The target is to keep the quick ratio above 1.1 to ensure that there are more current assets than current liabilities at all times. Greg needs more cash. Maybe he’s not collecting fast enough from his customers. Maybe his inventory level is too high. He needs more working capital for sure. The key will be to assess whether Greg’s liquidity squeeze is temporary or a long-term challenge.
Activity Ratios measure how effectively you are using your resources. The question is are you generating a good return on your business activities. Let’s look at the average collection period ratio.
Activity Ratio Example. Sandra is an advertising and media promotion specialist who designs complex ad campaigns and then schedules the roll-out to best suit her client’s needs. Sandra’s annual sales are $1,440,000, which divided by 360 translates to $4,000 in sales per day. Her receivables are listed on her balance sheet at $160,000. Sandra’s contracts stipulate payments are due within 15 days. Let’s use the average collection period ratio to track this activity.
Average collection period = receivables Target< 15
. sales per day
160,000 = 40
Sandra’s customers are taking 2-3 times longer to pay than stipulated in her contracts. She needs to accelerate collections or perhaps collect deposits or retainers to significantly reduce her average collection period. There is simply too large a gap between activity completion and payment for services rendered. 3.
Profitability Ratios are a family of financial ratios that measure returns on sales and investments. The question is are you making the target profits and margin that you expect. Let’s look at the profit margin ratio.Profitability Ratio Example. Mike runs a specialized packaging company that designs standard and custom packing materials for firms conducting on-site demonstrations. He is doing quite well as a new business in attracting clients. Mike sells $600,000 per year. His net profit after taxes is $40,000.
As you can see, a few simple financial ratios can tell you a lot about your business.
Even if you hate numbers, you can proceed quickly through your business operation to review what is actually happening vs. what you thought was happening. Assess whether liquidity, activity, or profitability analyses are a good place to start. There’s no one right answer; getting started somewhere is what’s important.
Perhaps you need more data. Go deeper if your data doesn’t seem to make sense to you. Maybe there is a large discrepancy between what you thought your costs were vs. what they actually are. And what your profits are vs. what you thought they were.
As you apply simple ratios you will gain significant insights about your business. But don’t stop there; the process can be repeated. After you boost profits in one area of your business, you can move to a new area or dive deeper. Profit maximization is a continuous process used by only the most successful business people. And after all, isn’t that the club you want to be in? You can routinely look for excess costs in your business:
Although a ratio can shine a light on one area of your business, they are taken at a single point in time. What matters most is the trend in your ratios. Are they moving in the right direction over time? How much does seasonality matter in your business? What would be more informative: a month-over-month look or would year-over-year be more accurate for your analysis? It is important to compare apples-to-apples and draw valid conclusions based on real data.
Most ratios involve only a few numbers. Many use simple division. Templates and on-line calculators that can be modified to suit your business are available to guide you. Graphics can be a big help to aid in your understanding of the information. After the data is in and the core analyses that provide powerful insights into your business are identified, most of these can be translated into visual images using pie charts, bar charts, trend lines, and other representations to better demonstrate the point. You can see the trends over time and use them to make better, more-informed business decisions.
Don’t let any aversion to numbers stand in the way of your dreams for your business. You now see the power of increased analytics and increased profits to change everything in your business. It’s true that knowledge, skillfully applied, is power.
After you find an interesting set of ratios – you can go deeper. Take a closer look at what is going on. Some ratios move together and show the same thing, others provide different views. Only you know your business and can glean the insights. The more you know about financial ratios and which ones are the most important for you to be tracking, the more business profit you can drive to your bottom line.
What’s the most important ratio or indicator in your business?