How are your Financial Ratios? Taking the Pulse of Your Company
Every trip to the doctor starts with a check of your vital signs. Why? Because they quickly indicate important information about your health. As an owner, you should be just as vigilant about monitoring the health of your small business by checking – on a regular basis – a few important financial ratios. I’m going to start with a couple that give you an indication of the general health of your business and then drill down to some that are more specifically targeted.
With a name like the “acid test” you know that we’re getting down to brass tacks here. By the way, this is also called the “quick ratio,” but I prefer the message that is delivered when you call it the acid test.
The acid test ratio is simply your liquid assets divided by your liability. You want this to be a number equal to or (preferably) greater than one. If your liquid assets and liabilities were equal, your acid test ratio would be one. If you owe more than your liquid assets, this would be a fraction.
The acid test gives you an idea of your ability to survive should you run into an unexpected problem that creates an expense. You’re really testing your luck if you owe significantly more than the cash you can quickly get your hands on.
Return on investment
How much did you invest to get your business going? Has it been worth it? The ROI ratio will tell you. Take your earnings and subtract the cost of your initial investment. Now take that number and divide it by your initial investment.
If your earnings were $50,000 and you spent $20,000 to start your business, the formula would look like this: ($50,000 – $20,000)/20,000 = 1.5 or a 150 percent return on your money. With this information, you can determine if you could have more wisely invested your funds.
The next formulas are extremely important to the way successful businesses are managed today and they have important relationships to one another.
If you sell products, you want them to be flying off your shelves or out of your warehouse. The inventory turnover ratio will give you that information. It is the cost of goods sold divided by the average value of your inventory. Bigger numbers are better.
If the cost of goods sold in one month is $2,000 and your average inventory during that time had a value of $1,000 this ratio is 2.0. It means that you (may) have done a good job restocking in a timely manner to meet orders. However, a business that has a drop in shipping agreements with manufacturers will be carrying no inventory…and this is even better!
It’s important that inventory turnover, like many other financial ratios, is compared to others in your industry. If the industry average is 3 and you’re at 1.5, you’re at a distinct competitive disadvantage.
Average collection period
This is the average of how long it takes all of your customers to pay their bills. Lower numbers are better. As with inventory turnover, it’s important to compare your average collection period to your industry average.
If the industry average is 10 days, and your customers are paying you, on average, in 30 days, your competitors are in a far stronger position. Something to consider here is how quickly you’re asking people to pay. If you’ve been doing net 30, change it to net 10 and see what happens; be sure to inform customers.
The last two financial ratios we have discussed – inventory turnover and average collection period – are critical today because in the current business climate “cash is king.” Healthy companies have healthy cash flows. This should be a goal and the best way to measure it is via the cash conversion cycle.
Cash conversion cycle
This formula is simple addition and subtraction. Take the number of days of inventory you have on hand, add to it how long it takes customers to pay you, and then subtract how many days it takes you to pay your suppliers.
If you didn’t carry any inventory and customers paid you immediately but you took 30 days to pay your suppliers, that would be a CCC of -30. In other words, you would be getting the financial benefit of a month’s worth of product for free.
Simply put, you want to hold a minimum amount of inventory, get paid fast, and take your own sweet time when paying your suppliers. I’ve heard reports that Amazon has had a -30.6 CCC and Apple has scored a -44.5. Those are incredible numbers and we see that those companies are awash in cash.
Here’s an easy strategy: Get good terms from your suppliers, hold off paying until the end of the grace period, and then put the cost on a business credit card, so you can take advantage of another grace period!
With these five financial ratios, you’ll get a great picture of the health of your business. Further, studying them will help you devise strategies to improve the financial strength of your company.