You know that numbers are necessary for the success of your business, but may not love talking about formulas and ratios. In this episode, we are talking about the power of numbers. More specifically, we’re breaking down liquidity ratios in your business. But, don’t run yet! We promise we will make it easy for you! We are giving you the formulas to calculate your ratios, common ratios to review, and, most importantly, we give you action steps you can take to improve your ratios. Another ratio you may want to consider measuring is your profitability ratio, covered in episode #58.
What we cover in this episode:
- 02:30 – Using ratio data (liquidity ratios) to gain insight
- 03:56 – What are liquidity ratios?
- 05:10 – Current ratio
- 07:13 – Current vs. Long-term
- 09:26 – What should my current ratio be?
- 10:24 – Taking action based on current ratio
- 14:29 – Specific actions to take
- 16:11 – Quick ratio
Using ratio data (liquidity ratios) to gain insight
The reason to look at ratios is because they provide insight into the performance of your business. This valuable data enables you to interpret trends and can reveal emerging problems. Ratios can help you see areas in your business with room for improvement so you can take action. On the flip side, seeing evidence of success and knowing your strengths can help build your confidence. In order to know where you stand with your business, you have to start by looking at your balance sheet. As we’ve talked about before, we recommend reviewing your balance sheet on a regular basis and understanding all of its content. The ratios we are talking about today come from your balance sheet.
Gain insight through comparisons
Once you are familiar with the information provided on your balance sheet, including the ratios, you can compare performance to prior time periods. Comparisons allow you to see if your business is improving or declining, if you need to refocus your attention, and how you measure up to industry benchmarks. Essentially, analyzing the data from your ratios allows you to recognize trends and see the big picture.
Common ratios include liquidity, solvency, efficiency, and profitability ratios. Today, we are going to be focusing on liquidity ratios. These are the most common because they tell business owners if they have the ability to quickly generate cash from their assets.
What are liquidity ratios?
Liquidity ratios are the most common and relate to the ability of your business to quickly turn some of your assets into cash. When looking at your balance sheet there are only two liquidity ratios, the current ratio and the quick ratio. These ratios are similar. In simplistic terms, both ratios give you the ratio of what you own, compared to what you owe.
Current ratio
The formula to calculate your current ratio is: TOTAL CURRENT ASSETS ÷ TOTAL CURRENT LIABILITIES.
- Current assets include cash, accounts receivable, inventory, and even some of your prepaid expenses.
- Current liabilities are things like accounts payable, credit card payments, payroll taxes payable, sales tax payable, and client deposits you’ve received but may not have earned yet. These are things you may have to pay back quickly.
EXAMPLE: Company Z has total current assets of $100,000 and total current liabilities of $75,000. The current ratio for Company Z is $100,000/$75,000 = 1.33
Essentially, the formula divides the amount of what you own by the amount you owe.
Current vs. long-term
In the accounting world, the word “current” is relative and actually refers to the time frame of less than one year, so it’s not actually current. Any time frame longer than one year becomes “long-term.” For example, if you owe something that isn’t going to be paid off for more than one year, that would be a long-term liability.
What should my current ratio be?
The current ratio is a calculation that shows you if you have enough assets to cover your liabilities. The current ratio is important because it helps you see how you will be able to manage if everything has to become liquid and you have to pay off all your liabilities suddenly. A healthy current ratio is also needed when you are trying to get a loan. The bank looks at these ratios to see if your business is in a good position to be able to pay on the loan. Ideally, in regards to the overall health of your business you want to have more current assets than current liabilities. A general rule is that your current ratio should be two to one (2:1) or better. We’d like for your current ratio to be two or higher. If your number is at least more than one, your business has more money than you owe. This number gives you a sense of how liquid your business is. If you owe quite a bit more than you have, your business is not very liquid. You want your business to be in a good, stable financial position; that’s where the two to one, or better, comes in.
Taking action based on current ratio
If you discover your ratio is not where you want it to be and there are potential issues, you can put plans in place. There may not be an issue today, but it could become an issue in the future. When you have a sense for where your business stands, you can make changes before things become catastrophic.
Specific actions to take
If you run your numbers and the result is 1.3 or less, there are things you can do to increase your current assets without increasing your current liability.
Options to increase your current assets:
- Increase your current assets from a loan.
- Increase cash by contributing cash as the owner of the business. This would increase your cash and impact your equity in a positive way which would improve your liquidity ratio.
- Convert some non-current assets into current assets. If you have older equipment that has been capitalized over lots of years that you don’t really need anymore, you can try selling it. When doing so, sell it for cash instead of taking payment as a long-term asset, sell it. You can gain a current asset when you sell something like this for cash.
- Pay off short-term debts or at least come up with a plan to get those debts paid
- Use some earned profits to put back into the business if you are doing well and have extra money.
Current vs. long-term
In the accounting world, the word “current” is relative and actually refers to the time frame of less than one year, so it’s not actually current. Any time frame longer than one year becomes “long-term.” For example, if you owe something that isn’t going to be paid off for more than one year, that would be a long-term liability.
Quick ratio
The quick ratio is a bit different than the current ratio. It is for companies that have a substantial amount of inventory on their balance sheet. If you don’t have inventory, this ratio is not going to be any different than your current ratio.
The formula itself is: (TOTAL CURRENT ASSETS – INVENTORY) ÷ TOTAL CURRENT LIABILITIES
The only difference between current and quick ratios is that the quick ratio removes inventory. Inventory can fluctuate from time to time and may throw off the current ratio, which is the purpose for this ratio. So, the quick ratio allows you to pull inventory out of the equation to determine the rest of the current assets over current liabilities. With this ratio, the general rule of thumb is to have the result be one-to-one. For companies with inventory that fluctuates, reviewing and comparing your current ratio and quick ratio is helpful to give you a different perspective.
Conclusion
Today seemed like a quick episode, but it was packed with useful information to help you understand your data. We started with reminding you to review and understand your balance sheet because that is where your ratio data comes from! The data provided in your balance sheet allows you to analyze the overall health of your business. There are only two liquidity ratios on your balance sheet, the current ratio and the quick ratio. These ratios show you what you have compared to what you owe. We care about this because it shows you the overall health of your business and whether or not you need to take action. If action is needed we shared some specific things you can do to increase your current assets, which will adjust your current ratio. Lastly, we ended the episode talking about the quick ratio which is similar to the current ratio. The only difference is the quick ratio is beneficial for businesses with significant inventory because the equation factors in inventory. All in all, take time to look over the information you have at your fingertips and know what it means. The success of your business could depend on it.
