How healthy is your business?
The balance sheet and the income statement represent a complete financial picture of your company
The idea of this post is to take your financial information and develop a set of measurements that will allow you to monitor both your current position and your progress.
The ratio doesn't care about the absolute size, the only care about the relationship. It is this relationship we can use to measure and manage your financial effectiveness.
Clearly, the question that arises is which relationship to measure?
The action steps are simple:
To lay out your statements in a spreadsheet format is nothing more than putting all the financial data on one sheet, side by side, by year.
You operate and manage your business with limited resources, management, capital, and time.
This process being described is merely an efficient, effective method to keep your finger on the pulse of your company.
Measures Solvency: The current number of dollars/euros (you name it) in current assets for every $1 in current liabilites.
If HIGH may indicate an imbalance in the investment in long-term assets, or an economic condition conducive to maintain high liquidity.
If LOW may indicate financing long-term assets with short-term money.
Quick: (Cash + Accounts Receivable) / Current Liabilies
Measure Liquidity: The number of dollars/euros (you name it) in cash and accounts receivable for each $1 in current liabilities.
If HIGH may indicate an excess of cash. Normally implies under-investments in inventory. The effect normally shows up in reduced sales and reduced profits.
if LOW may manifest itself in a shortage of cash, and usually indicates problems similar to current ratio and/or problems associated with over investments in inventory.
Debt to Worth = Total Liabilities / Net Worth
Measures Financial Risks: The number of dollars/euros (you name it) of debt owed for every $1 of net worth.
if HIGH too much risk, leveraged is too great. If the economy goes bad and sales decrease, interest expenses can destroy profits. Often caused by unmanaged growth.
If LOW your business is too safe, not enough risk equates with not enough return. There is too much equity in the your business and too much debt capacity causing low ROI.
The next post will address other useful business ratios, in the meantime, you can read basic management for improving cash flow in your business.
The idea of this post is to take your financial information and develop a set of measurements that will allow you to monitor both your current position and your progress.
Making valid comparisons:
A ratio is nothing more than one number in relation to another. They have the very practical property of reducing a relationship to a single number, no matter the size of the two numbers involved.The ratio doesn't care about the absolute size, the only care about the relationship. It is this relationship we can use to measure and manage your financial effectiveness.
Clearly, the question that arises is which relationship to measure?
The action steps are simple:
- You need financial statements for at least three years or as many as you have.
- You need to lay out your statements in a spreadsheet format,
- Use the same spreadsheet format to calculate your financial ratios.
To lay out your statements in a spreadsheet format is nothing more than putting all the financial data on one sheet, side by side, by year.
Using ratios as tools:
There are three ways to use these ratios to analyze your business:- To compare your current performance to your performance over prior years -your trends,
- To compare your present performance to others in your industry,
- To compare your ratios to your plans in developing a workable operating strategy.
You operate and manage your business with limited resources, management, capital, and time.
This process being described is merely an efficient, effective method to keep your finger on the pulse of your company.
Balance sheet ratios
Current = Current Assets / Current LiabilitiesMeasures Solvency: The current number of dollars/euros (you name it) in current assets for every $1 in current liabilites.
If HIGH may indicate an imbalance in the investment in long-term assets, or an economic condition conducive to maintain high liquidity.
If LOW may indicate financing long-term assets with short-term money.
Quick: (Cash + Accounts Receivable) / Current Liabilies
Measure Liquidity: The number of dollars/euros (you name it) in cash and accounts receivable for each $1 in current liabilities.
If HIGH may indicate an excess of cash. Normally implies under-investments in inventory. The effect normally shows up in reduced sales and reduced profits.
if LOW may manifest itself in a shortage of cash, and usually indicates problems similar to current ratio and/or problems associated with over investments in inventory.
Debt to Worth = Total Liabilities / Net Worth
Measures Financial Risks: The number of dollars/euros (you name it) of debt owed for every $1 of net worth.
if HIGH too much risk, leveraged is too great. If the economy goes bad and sales decrease, interest expenses can destroy profits. Often caused by unmanaged growth.
If LOW your business is too safe, not enough risk equates with not enough return. There is too much equity in the your business and too much debt capacity causing low ROI.
The next post will address other useful business ratios, in the meantime, you can read basic management for improving cash flow in your business.
About Daniel Vukasovich
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