How to make good use of the paper your accountant gives to you (part 2)

In the previous post we discussed the margins as health indicators for your business. They’re the simpler and most basic of all the indicators that you can get from the three sheets prepared by your accountant: the income statement, the balance sheet and the cash flow.

Now we focus on some other financial indicators that can tell you something insightful about how is your company doing.

From the balance sheet you can get the Current Ratio defined as:
(current assets)/(current liabilities)

It is the ratio of what you collect in the short term to what you have to pay in the short term (that’s the meaning of “current”). To make a long story short:
Current Assets = Cash +Bank + Debtors + Bills Receivable + Short Term Investment + Inventory + Prepaid Expenses
Current Liabilities= Accounts payable+Accrued expenses+Income tax payable+Short-term notes payable+Portion of long-term debt payable

This ratio measures if a company can withstand its obligation relying on its ordinary operations, in simpler words, if you can pay what you need to keep the company running without raising capital. This ratio must be higher than 1, because current liabilities should pay also for long term liabilities, if any. Keep an eye on this ratio and keep it higher than one.

Also be careful to check how much the term “inventory” weights in the total of Current Assets. In many businesses the inventory has a high value that can’t be turned into cash quickly (because what you need to create your product has a very long delivery lead time and you must stock in advance enough supplies to meet the demand, for example). If it’s the case, you can write the term off to calculate the ratio; it’s a cautious assumption.

Somewhat related to the Current Ratio is the Quick Ratio, which is defined as
(cash + accounts receivable)/(accounts payable)

This is faster to be calculated and can be checked weekly or daily. Its meaning is not much different than the Current Ratio but is more tied to the day to day operations. Once again, keeping this ratio well above 1 is a good, albeit not absolute, shield against a cash crisis.

In the next post, we’ll dig deeper and we’ll learn about the defensive numbers for a business.

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