For most small businesses, financial ratios are about as dry as the Sahara desert. While I can't make them fun or sexy, hopefully, I can help you understand why they are important.
They can give us an easy way to gauge the health of your business. COVID and the botched reopening has pushed many small businesses to the brink of bankruptcy. If you want to avoid this fate, it is important to focus on both liquidity and solvency.
In plain English. Both liquidity and solvency focus on having enough cash. How fast can you generate it, and do you have enough to pay your bills?
The first story is about Hattie's kitchen, a small cafe in Brooklyn. Hattie made some miscalculations when she reopened post-COVID after she came very close to closing for good.
Like most restaurants, she was planning to reopen to more than just outside dining. Hattie made some inventory decisions based on her expected demand. When that demand did not materialize, she was in trouble. Hattie wasn't paying attention to her small business financial ratios until it was almost too late.
Hattie had a liquidity problem. James Chen and Gordon Scott from Investopedia define liquidity as:
Liquidity refers to the ease with which an asset, or security, can be converted into ready cash without affecting its market price. -James Chen
She had too many assets tied up in inventory that she couldn't easily convert into cash because customers weren't there.
The formula is pretty straight forward:
Current assets include cash, accounts receivable, bond, stocks, etc. All are items that can be converted into cash with a fiscal year. Inventory is the cost of the all the stock you have on hand of finished goods, work in progress, and/or raw materials. Current liability are bills that are due within a fiscal year.
We use the sums of these to calculate our financial ratios. While some small businesses won't carry inventory, all will have assets and liabilities.
This formula can tell you if the business is on fire. If this ratio is less than one, you can't cover your bills. You will need to convert assets to cash quickly, or you'll be bankrupt.
Unfortunately. given the stresses COVID has put on demand, many small businesses are slipping toward 1, and that is a major problem.
If Hattie had seen that her ratio was very close to 1, she could have acted sooner. She could have tried to sell off some of her inventory to other stores or revamped the menu to focus on consuming the ingredients that were most at risk of spoilage.
But she didn't. Hattie didn't realize until the quick ratio was <1. The house was on fire. Luckily, she got a 0% loan to help put out the fire before the business burnt down.
Hattie is illustrative as to why I recommend following small business financial ratios monthly.
Wine and cheese may get better with age, but not accounts receivable. They can be like cement blocks the drag you down.
Paul runs a small service B2B business. Paul was able to operate during COVID, but operating while others were closed created other issues. It caused customers to delay payments to Paul until he ran short on funds to make payroll.
Paul's Quick Ratio was alright, so everything should have fine, right? Wrong. Most of his current assets were tied up in accounts receivables, which bring us to our second small business financial ratio.
Paul noticed that his clients were paying late, but he didn't think it would be a problem... until it did. If he were tracking our second small business financial ratio, he would have known he was in trouble.
According to Michael Grant and Investopedia, days of sales outstanding is defined as:
Days sales outstanding (DSO) is a measure of the average number of days that it takes a company to collect payment after a sale has been made. DSO is often determined on a monthly, quarterly or annual basis - Michael Grant
DSO financial ratio can be calculated by
The larger this number is, the more cash is tied up by clients that owe you money. Thirty days is standard. If this is greater than 30, you should look for ways to get your clients to pay faster.
Paul's clients paid more around the 40-day mark, which put him in a real bind because he paid his employees monthly.
Jack runs Palomino. He has been in the painting and general contracting business for over 15 years. Jack has a lot of small business experience under his belt.Â
While Jack had jobs lined up before COVID hit, they were all put on hold. Luckily, these were commercial jobs, so they all had contracts will a cancellation clause. Jack worked hard to get those clients, so he wanted to see if he could offer them the option to delay.
He knew it would hit his liquidity, but he could manage that. His bigger issue was the debt he owed. He had to make sure he would have enough cash to cover his expense while paying off his debt before he offered this deal.
This brings us to the concept called solvency. Adam Hayes and Julie Young from Investopedia define solvency as:
Solvency is the ability of a company to meet its long-term debts and financial obligations. Solvency can be an important measure of financial health, since its one way of demonstrating a company's ability to manage its operations into the foreseeable future. - Adam Hayes & Julie Young
Solvency and liquidity can be linked, but that's not always the case. Paul was a great example of a solvent company that had liquidity problems. Jack was the opposite.
His issue was a loan he took out a few years back to pay for some much-needed equipment. He had enough cash to manage the short-term, but he wasn't sure if he could manage the longer-term.
This brings us to our final small business financial ratio, which is the debt-to-cash (DCR) or debt-to-income ratio.
This ratio looks across several months, generally 6 or 12 months, to see how much cushion the business has after covering its debts. If this small business financial ratio is less than one, you don't have enough cash to pay your debt. If you're only marginally over 1, then minor setbacks can create major problems.
Jack went to his accountant and said, "How long could we offer our clients a delayed start or hold on a current job before it gets too risky?" Here's what the sales and expenses will be. When he did the math, he calculated that Jack to offer up to 4 months of a delay, after which he must invoke the cancellation charge in order to have enough cushion to run the business without undue financial stress.
Hattie was a great example of how a mismatch in demand and inventory can wreak havoc quickly. Jack illustrated why it's important to keep an eye on how long your invoices are outstanding. Finally, Jack was a great example of what to do to ensure that your business stays solvent when hit with an unexpected drop in demand.
While small business financial ratios might not be sexy, I hope you understand now why they are so important, especially now, given all the uncertainty we face. To recap the 3 small business financial ratios that COVID made critical:
These aren't the only financial ratios that matter to small business. These are only those that COVID has critical due to the stress it has caused on cash flow and demand. Having a great accountant is vital to the success of any business. Be sure you have the help you need.
Brian Cairns, CEO of Prostrategix Consulting. Over 25 years of business experience as a corporate executive, entrepreneur, and small business owner. For more information, please visit my LinkedIn profile
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