Financial reports can hide a multitude of false positives. Sales have increased but your best customer has fallen to number five. Assets have increased dramatically but it’s because you really have too much inventory. Your gross margin is 15% and you have cut everywhere imagineable. It’s very tempting to just use your accounting software to get the reports and then forget them until, oh say, disaster strikes. (Do NOT get me started on the “trusted bookkeeper” subject!) Here’s a way to really get in touch with your true financial position and make sure your company is going where you want. There a number of ratios that compare one set of data with another. You should look at them over time as trends preferably years but start looking as soon as possible. A one time order can make a great profit for one day or one month. Does it make up for a series of lackluster profits over six or eight months? Can you find another one time order when you need it or should you cut expenses? Layoffs are a quick simple (I didn’t say easy) fix to increase profits unless you have to increase overtime. Once again a short term solution to a perhaps long term problem. Another important consideration is checking your ratios against similar companies within your industry. A grocery store won’t have the same ratios as a software developer or a high end bicycle manufacturer. That doesn’t mean these companies don’t have happy owners; it means they understand the uniqueness of their operations. The Missouri SBDC has seventeen different ratios listed under four categories: Liquidity, safety, profitability and efficiency. We will discuss several but it is by no means comprehensive. Make sure you know the ratios most important to your company. Liquidity Can you pay your current obligations as they come due? This is all about how much cash you have and what can you convert to cash if necessary. There are two ways to look at it. Current Ratio: The ability to pay today’s bills with today’s money. Take all current assets (cash, accounts receivable, inventory) and divide it by current liabilities. General rule of thumb? Total Current Assets/Total Current Assets = 2 or a ratio of 2:1 Quick Ratio: Also called the acid test it does not include inventory. Can you meet your current obligations without selling inventory? All Quick Assets/Current Liabilities = 1 or a ratio of 1:1 Profitability If you don’t have a profit there is no cash to run the business even if there is money in the bank. On the other hand a high profit does not necessarily mean high cash reserves. Both liquidity and profitability must be analyzed at the same time. Gross Profit Margin: How well can your business generate a return by addressing inventory control, pricing and production efficiency. There is no rule of thumb ratio here except you want it trending upward from 0 towards 1. Gross Profit/Total Sales Net Profit Margin: This ratio shows the competence of the company to manage its operating expenses and can indicate if there is enough sales volume to cover fixed costs and still make a decent profit. You get to decide what the right number is here. Net Profit/Total Sales Efficiency This is how you judge your assets on both value and how effectively they are utilized. Remember you may need to turn some into cash or you may use them as part of a sale agreement. These two categories are often discussed when there is a downturn in the economy. Demand your customers pay quicker and don’t pay your creditors as quickly. A slippery slope as you may alienate your best customers and annoy your vendors both of whom you need. May be the right thing to do but don’t make it a knee jerk decision. Think long and hard about changing your terms. Accounts Receivable: This assumes you have accounts receivable. Many companies are credit card only, Paypal or some other sort of cash in advance. It is the best possible way. If you can’t do that here are the two ratios you need. The first you want a high number. The second should be as low as possible. Total Net Sales/Accounts Receivable = AR Turnover 365 Days/AR Turnover = AR Collection Period
Accounts Payable: How well you use early pay discounts or how long you are holding on to your money can be seen here. Like accounts receivable you may have very little if the vendors you are dealing with may want their money up front too.
Cost of Goods Sold/Accounts Payable = AP Turnover
Become familiar with these terms and any others that affect your business. They are tools. Just like you wouldn’t refuse to look at the ads you are running or address a customer service problem financial ratios and reports indicate if you are getting what you want from the blood, sweat and tears you have been and will continue to pour into your business. It’s the only way really.
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