Small business finance. Many entrepreneurs that I talk with say this is one of their biggest fears – trying to monitor the financial performance of their company. As we have highlighted in other posts the back bone of the financial side of the business is the accounting system.
Your company generates data everyday and the accounting system becomes the mechanism which you track your performance. But once you put all of your data into that accounting software, what does it mean? How are you doing? How do you know? The surveys are out there suggesting that over 50% of small business owners struggle to understand certain aspects of their finance and accounting. 50 percent. Think about that.
You are not alone and the best thing you can do is find a resource that allows you to ask relevant questions. We are going to break this post into two sections and give you six useful financial ratios or metrics to help monitor your company performance. So, let’s take a look at the first set of ratios!
Current Ratio: Current Assets/Current Liabilities
– The current ratio, or liquidity ratio, gives you an idea of the company’s ability to pay off its short-term debt. Generally speaking, any number under one would indicate the company would be unable to pay off outstanding loans or accounts payable. Inversely, a ratio over one is an indicator the company has the ability to pay off its obligations. This ratio provides a small business with an idea into the operational efficiency of a company and gives you the starting point to gauge how the day-to-day accounts receivable and accounts payable impact cash. It is important to note that different industries have different benchmarks for a current ratio. We would advise you look to see where your company should be before you let the ratios get the best of you.
Inventory Turnover: Sales/Inventory
– To start, you may calculate this ratio by substituting Cost of Goods Sold for sales, as sales are typically shown reflecting market value. What this number will tell you is typically how many days or periods it is taking the company to sell inventory. Depending on the industry, numbers will vary. For example, for a grocery store, you would expect a higher turnover due to the shelf life of food products. If you let perishable items sit, they spoil, resulting in lost product and loss sales. For a used car dealership, you may typically have inventory (used cars) that sit on the lot for anywhere from 30 to 45 days, which may be typical. We would recommend comparing inventory turnover to industry averages. The other important factor to consider is the amount of time inventory sits on your books, this is also a cost to carry the inventory.
Average Collection Period: (Days * Accounts Receivable)/Credit Sales
– How quickly are you getting paid? For cash flow purposes the collection period is extremely important. Remember, your business has inflows and outflows. This number will tell you how many days on average it is taking you to collect payment from customers. When companies compare the payment terms with vendors (usually 30 days) you will see why this can become an issue. To calculate the ratio, multiply the number of days in the period (monthly, yearly, etc.) by the accounts receivable balance from the company balance sheet. Once you have that total, divide the number by total credit sales for the period.
So that is what we have for you for Part 1! It is important to note that to compile this information you will need to make sure your profit and loss as well as your company balance sheet are clean with good data. These ratios are incredibly helpful to manage the business but it is not powerful unless the information you use is accurate. Check back for Part 2 for the next three ratios!
To learn how we can help your business, visit www.mokercpa.com