As an owner, leader, or manager of a finishing and coating operation, your ultimate goal should be to maximize the value of your business over the long term.
Jim CastigliaRatios are a very effective way to measure a company's financial progress at a given point in time.
The good news is that you don’t need to use many ratios for your financial analysis. A financial analyst might use dozens of ratios, but you only need to know a handful of the most effective ones. This article will get you started.
Last month’s article focused on the three key report cards of any business:
- The balance sheet
- The profit and loss statement
- The cash flow statement.
3 Types of Ratios to Know
The ratios you’ll need will come from these three reports. And, just as there are three report cards, there are also three types of ratios to know:
- Liquidity ratios
- Profitability ratios
- Efficiency ratios.
Liquidity ratios measure the amount of cash available to cover your expenses. I’m sure you’ve heard the maxim, “Cash is king!” and/or “Never run out of cash.”
Liquidity ratios are powerful tools for measuring and controlling cash and avoiding going out of business. (One strategy to address cash concerns is to have a healthy line of credit with a lending institution.)
In this article, I’m presenting three liquidity ratios you can start using to better control your operation:
- Current ratio - measures your ability to pay your current liabilities
- Turnover of cash ratio - measures the turnover of working capital
- Debt to net worth ratio - measures your leverage.
Let’s look at each ratio in more detail.
Current Ratio
The generally accepted standard is that your current assets should be two times or 200% of your current liabilities. Get this information from your balance sheet. A low ratio may indicate difficulty paying off bills, an inability to take advantage of discounts or other good terms, and unhappy suppliers who reduce eager service to you and your company. A high ratio could mean your money is tied up and not working better for you.
If you remove inventory from your asset calculation, that’s called the “quick ratio.” A safe margin quick ratio would be at least 1.0 times.
Turnover of Cash
The generally accepted standard here is that sales should be 5 or 6 times working capital. Get your working capital number by subtracting your current liabilities from your assets. It’s called working capital because it’s the amount you need to operate your business daily.
A low ratio could mean you have money tied up in short-term low-yielding assets. A high ratio makes you vulnerable to creditors because you could have difficulty paying wages or utility bills. If your CA-to-CL ratio is low, the cash turnover will be high. It’s because of the small amount of working capital available.
Debt to Net Worth Ratio
The generally accepted standard by many analysts is that current liabilities to net worth shouldn’t exceed 80%, and long-term debt shouldn’t exceed net worth by 50%. The more debt you carry, the more creditors want to have a say in your company’s operations.
A low ratio means greater long-term financial safety, just like in your personal life. Creditors like people with low debt. Watch out for being too conservative, which may indicate you’re not optimizing profit. A high ratio means your creditors are taking on more risk and are more interested in how management runs things.
Next month, we will look at the profitability ratios.
If you’re not already using ratios to measure and control your business, start with these three valuable liquidity ratios. Measure your progress and, most importantly, look for trends. Make sure your top people understand these business controls fully. And aim to constantly enhance your financial acumen. Don’t be afraid to speak with your accountant about these factors. I rarely find business owners taking full advantage of their accountants, who can be extremely valuable contributors to your organization’s success.
If you need assistance, contact me at my personal email, jvcastiglia@icloud.com, or at 949.338.7141.
Jim Castiglia is the founder of Business Street Fighter Consulting and supports entrepreneurial business owners in their desire to grow and maximize the value of their business. He can be reached by email at JimC@BSF.consulting or by phone at 919.263.1256. Visit www.BSF.consulting
