These ratios and guidelines have been developed for the contracting industry. I have no clue as to whether they hold true in other industries since I don't work with companies other than contracting companies.
If your accountant or banker wants to look at other ratios, these can also be calculated. However, I would only calculate them if an outside advisor requests them. Remember, if the 10 ratios that I will discuss during the next few months are in line, then all of the ratios your banker looks at (that I personally don't care about) will be in line also.
This month we will discuss the liquidity ratios that I use. Liquidity ratios tell you whether you have enough cash coming in the door on an ongoing basis to pay your bills.
The current ratioCalculate this ratio by using figures from the balance sheet. The ratio is Current Assets : Current Liabilities. This ratio should be 1.75 to 2 or greater.
When examining the balance sheet, make sure the assets and liabilities appear in the proper locations. Current assets are assets that are either cash or will be turned into cash within one year. Make sure that property, buildings, loans to officers, etc. are listed as long-term assets rather than current assets. If you have borrowed money from the company, then a receivable is showing on your balance sheet. Be realistic- are you going to pay it back within a year? If not, then do not show this receivable in current assets.
Likewise, current liabilities are amounts that a company owes that are payable within one year. Make sure that long-term debt is listed as long-term rather than in current liability categories. Also, long-term debt should have a current portion. For example, if the company has a five-year truck loan with a principal payment of $250 per month (total payments of $15,000), then the balance sheet should show $250 x 12 or $3,000 in current liabilities.
Service agreement deferred income is a current liability as are accrued expenses and payroll taxes. If there are figures included as current assets or liabilities that should not be in those categories subtract them out before calculating the current ratio. Likewise, if there are figures that should be included in current assets or liabilities, add them in before calculating the current ratio.
Acid test or quick ratioThe acid test is also a measure of liquidity. It looks at the effect of inventory on your financial statement. You calculate this ratio by using figures from the balance sheet. It is calculated as Current Assets - Inventory : Current Liabilities. The ratio should be 1 or better.
Current ratio to acid testLook at the relationship between the current ratio and the acid test. If the ratio is greater than 2 (for example, if your current ratio is 3 and your acid test is 1) then you have too much tied up in inventory. The only time inventory may be at this high a level is at the beginning of the busy season. If it isn't, then the inventory figure is calculated wrong (when was the last time the company took a physical inventory?)
This ratio is absolutely useless if you don't track inventory and play what I call the "dart board game" ¿ i.e., how much inventory do I think I have? And guess at the figure.
If this ratio is out of balance the company must reduce its inventory level and use parts in the warehouse and on the trucks rather than going to the parts supply house when parts are needed. If the inventory is outdated, the it should be written off to reflect the actual inventory levels.
A stable or increasing current ratio and acid test are good. If the ratios are decreasing, then it is a warning sign to do something. The first thing that a decreasing current ratio and acid test tell you is that you have unprofitable sales. Check your pricing and make sure that what you are estimating in terms of labor and materials is actually going on the jobs. However if you have just paid cash for a new vehicle or other asset, your current ratio will usually go down. You are trading a short term asset (cash) for a long-term asset (the vehicle).
Next month I'll discuss other important financial ratios.
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