As a business owner, you are keenly aware of your sales and the balance in your bank account. For some of you, that is where your financial analysis stops. Others of you do spend some time on the rest of the income statement.
But almost no one ever looks at the balance sheet – or the ratios that go along with the balance sheet. I think that is a mistake so I would like to show you a couple of numbers to review every month along with the income statement. These numbers are a measure of financial strength and the company’s management. They should never be run in isolation, rather they need to be compared to historical numbers. Are your trends going up or down? I find this pretty important stuff.
Quick Ratio. This is meant to keep down the false sense of security because you have cash in the bank. The formula is: (Cash plus receivables) divided by current liabilities. Conclusions you can draw:
- This ratio wants to know if you have enough money to pay your bills. The bigger the ratio, the safer your company. For example a ratio of 2.0 means you have twice as much money as you need to pay your current debts.
- If this number is less than one, your company is struggling and you need to make some changes. You do not have enough cash (and receivables) to pay your bills. A management meeting is needed to fix this and a plan needs to be implemented immediately. You could already be in crisis if this is less than 1.
Accounts Receivable Days. The question is how long does it take to collect your money? The answer is A/R Days. The calculation is: A/R balance divided by (last 12 month of sales divided by 365). For example, if your A/R balance is 150,000 and sales for the last year are $1.0 million, your days outstanding is 54.75 days. While we all want to collect our money inside of 30 days, it doesn’t always happen. You want to use this number and challenge your collections person to bring it down.
Days of Inventory. How much inventory do you have on hand? The smaller this number, the better (keeping in mind you don’t want backorders). The bad news about too much inventory is it is a use of cash and the more you have, the more obsolete inventory you will write off. You need to establish this number and have your buyer maintain inventory at this level. The calculation is: Inventory balance divided by (last 12 month of cost of product divided by 365).
Debt to Equity. Divide your liabilities by your stockholder’s equity. Then call your banker and ask him what number the bank wants to see. If you keep the debt to equity ratio in line with what the banker wants, he or she will be more willing to make loans to you. This is somewhat of a measure of your “skin in the game.” If you have all debt and no equity, bankers are more reluctant to lend you money.
Sales per FTE. The question is: how much staff do you need to handle your current business? And is the staff number growing faster than sales? Typically, as companies mature, they take on staff bloat. This is a very costly number and one you will want to control. FTE stands for full time equivalents. For example, if you have 3 full time people and 3 part time people that each work 20 hours per week, you have 4.5 FTE’s (3 full time plus 1 ½ part time). Over time, as sales grow, you want this number to climb. For most of you, the number has been (unfortunately) dropping over time.
There are more metrics that I use to analyze my client financials, but these are probably the most important. The worst things to happen to you as a business owner is to get caught off guard by something bad. If you watch these numbers, you will see a trend early and fix the problem before it becomes a crisis.
Here is your call to action: give this post to your financial person and have him/her add these numbers to your monthly reports (income statement and balance sheet). Have them prepare a graph of the last 13 months so you can track trends. If they get stuck putting this together, have them call me.