Q: I’m trying to get a handle on the overall health of my business. I’m convinced that I should be doing far better than I am, but I don’t know how to pinpoint the glitches that are holding me back. How do I get started and what do I look for?
A: The best place to start is with your company’s financial statements. Since they don’t make great bedside reading, these data-laden reports typically get little attention. But a careful analysis of some other key numbers is needed to produce the action-guiding insight that will facilitate performance improvement.
The ratios produced by juxtaposing key numbers in your financials will direct you to the specific things that you can do to improve operational results.
• Sales and Working Capital Ratio (net sales divided by net working capital): Some entrepreneurs boast about “operating on a shoestring,” i.e. great sales with little cash invested in the company. Not a good idea. A high ratio will make it difficult for you to get other peoples’ money. Your creditors watch this ratio since the lower the ratio the better the coverage they enjoy. A low ratio might also indicate that your working capital is not being employed efficiently.
• Current Ratio (current assets divided by current liabilities): The result is an indication of a firm’s ability to service its current obligations. Obviously, a high ratio is a positive indicator, but the composition and quality of the assets must be considered also. Lenders watch this number very carefully. A chronic cash shortfall is one of the biggest threats to rapidly growing businesses as well as weak businesses.
• Quick Ratio (cash and equivalents plus trade receivables [net] divided by total current liabilities): This acid test eliminates inventory from consideration and reflects the degree to which your company’s current liabilities are covered by only the most liquid current assets. Any value less than 1 indicates that you might have to liquidate inventory or other assets to pay short-term debt. The problem here is that these kinds of assets don’t command a big buck when they have to be liquidated quickly. Banks want to see a ratio of 1, at the very least. Too many squeezed entrepreneurs are tempted to use the cash-in-hand that’s earmarked for the payment of employee withholding taxes and other IRS obligations. Don’t give in! This subtle debt balloons quickly, and the IRS will catch up with you sooner or later. The IRS will regard this as a personal debt as well as a company obligation and the associated interest charges and penalties can put you in the poorhouse overnight.
• Sales/Receivables Ratio (net sales [excluding cash sales] divided by trade receivables [net]): This ratio shows the number of times receivables turn over in a year, i.e. how many days it takes you to collect on a credit sale. If you offer customers 30-day terms, your receivables should turn over at least 12 times a year. The higher the ratio, the shorter the time between sale and cash collection. If this is a low number, your collection policy might need some fine-tuning.
• Receivables Collection Ratio (accounts receivable divided by daily sales): This reflects the average time receivables are outstanding and is a gauge of the effectiveness of your overall collection procedures. At the end of each month, prepare a listing of unpaid invoices and note the age. This aging schedule will tell you which customers to chase most aggressively.
• Inventory Turnover Ratio (cost of goods sold divided by inventory): This shows the number of times inventory is pushed through your company in a year. High turnover reflects a good liquidity situation and can also mean that you are doing a bang-up job selling. But examine the circumstances carefully, since it can also indicate that you carry too little inventory and “stocking out” can eventually create problems with customers.
When there’s low turnover (i.e. poor liquidity), check for overstocking or inventory obsolescence. By dividing your firm’s inventory turnover ratio into 365, you will be able to calculate the “average number of days in inventory.” This tells you the average amount of time an item is sitting in inventory. Obviously, the less shelf time the better. By adding your inventory turnover in days to your A/R turnover in days, you can calculate the complete operating cycle of your business. This is the sum of the days it takes for you to move your inventory plus the number of days it takes to get paid after that inventory is sold. Your firm’s cash is tied up during that period, so you want as short an operating cycle as possible. Business owners generally strive to extend their payables period (the average number of days it takes to pay off invoices) to match their operating cycle so that their company keeps as little cash as possible tied up in making, selling and collecting.
As you can see, there are two sides to every ratio. Make sure you know what they imply both individually and in counter position to each other.
Paul Willax is a professor of entrepreneurship and chairman of the Center for Business Ownership Inc., Amherst, N.Y. He also is the author of the book, “Brass Tacks Tips for Business Owners,” available at barnersandnoble.com. If you have a question or suggestion for his column, or to receive a free, weekly e-mail newsletter, “Brass Tacks Brainfood,” write to Willax@TheBrassTacks.com.