3 ratios that will help you see what you own and owe
This article originally appeared in the July 2016 edition of INSTORE.
If you’ve spent any time looking at a set of financial statements it will generally consist of two parts: the profit and loss account and the balance sheet. Most business owners have a handle on the profit and loss and what it measures but only a few read far enough to understand or interpret the latter. Today we’re going to talk about a few ratios that can help you know what’s going on with your balance sheet.
Whereas the profit and loss measures a time period (the sales and costs over a financial period) the balance sheet tends to be a snapshot of the date in question. It shows what the business owns and what the business owes at that point in time. Whereas the profit and loss shows what comes in and goes out, the balance sheet tends to show what happens with the money that is kept (as cash or assets) and how they have been paid for (with money or debt).
Here are a three ratios that will help you understand it better:
1 The Current Ratio. Sometimes called the liquidity ratio. This is Current Assets/Current Liabilities. What does that mean? Current assets are things the business owns that can be turned into cash quickly (cash, inventory, debtors, etc). Current liabilities are debts that have to be paid now (a bank overdraft, creditors, a tax payment due next month). Ideally you want a ratio of 2.0 or more — $2 of cashable assets for every $1 of money owed now. This is your ability to deal with short-term obligations. I have seen many asset-rich businesses almost driven bankrupt because they have short-term debt but their money is tied up in assets that can’t be cashed up quickly and easily.
2The Debt Serviceability Ratio.This measures the ability of a business to meet interest charges and other costs associated with debt, and is something a lender will look at closely. This ratio measures the cash profit/debt-servicing costs. If you make $100,000 in cash profit and have $10,000 in interest charges each year then your servicing ratio will be 10 ($10 of profit for every dollar in interest costs — this doesn’t take into account any balance repayments of the loan)
3 Operating Cash Flow to Current Liabilities. This is the ability to meet your short-term current liabilities from profit rather than from current assets as in the first example. The business cash flow is the cash profit (not counting depreciation or other not cash costs) divided by the current liabilities. This shows the ability for the business to meet its immediate obligations from its trading rather than from cashing up assets.
These are all short-term measures of the ability of the business to meet its immediate obligations. We will look at other ratios in a later article.