Is your business in good financial health? Check it with the help of ratios! Part 1

I truly believe that accounting ratios are underestimated, and not used often enough by self-employed and small business owners. I often wonder why. Maybe some of them think that the ratios are only useful for big companies that have millions of pounds worth of revenues, or they just think they are too complicated? Maybe some of them even think that the ratios don't bring enough value, and spending time to calculate and analyse them is just a waste of time? It might seem, that you know your business' financial health just by looking at your bank account statement, or list of orders for this month, but believe me when I say, that that's not enough.

Why ratios then?

Ratios are a simple way (yes, simple! - read on, and I'll show you) of bringing your attention to the details that really matter to the health of your business, which you might not always be looking at. Not using ratios, you are risking missing out on important informator and overlooking warning signs. Think of the accounting ratios, like the medical tests that are done to a person - blood tests for example. You give your blood sample, send it to the laboratory, they perform some tests and send you back a report with some numbers on it. Then a doctor looks at the numbers, interprets it and explains it for you. With this information, you can take better care of yourself. You might even find out that there is some health problem that you haven't known about before. If that's the case, you will start treatment. You could do the same for your business, and hire an accountant or a business consultant to perform a business health check for you (and I believe it always is worth your money, once you find an expert that you trust) but, although I wouldn't recommend taking your own blood sample and performing tests on your blood at home, you could definitely perform a simple health check for your business yourself, that will help you stay well informed and know when to act to keep your business' form tip-top. You should really get into the habit of calculating a few of the most useful ratios regularly. It's a little bit like checking your weight every week, calculating the calories that you consume, or measuring your temperature when you feel under the weather - habits, that some of you already have to keep your own health in check.

In this week's post, I will write about two of the most important, and well-known liquidity ratios: current ratio and quick ratio. I'm starting my series of posts about ratios with these ratios because I believe they will give you the most critical information about the health of your business. They answer a simple question: 'Is my business capable of surviving in a time of difficulty?'. This is a question every business owner should be asking themselves. You can have the most successful business, but there's no use of it if in the time of difficulty it hasn't got enough liquidity to survive so that it can carry on thriving again after turbulent times are over. We all can see proof of that during the unfortunate times of Covid-19 pandemic.

Current ratio & Quick ratio

These ratios are meant to check the liquidity of your business. It means they check how good is it with cash. Is there enough cash and other quick-to-sell assets to cover for your current liabilities? You may ask why is it important? You never know when the bad stuff will happen, and chances are, bad stuff will happen eventually. When it does happen, and you lose a major part of your revenue, can you stay afloat? Can you repay your liabilities without having to get in debt, or even closing the business down? These ratios will help you answer these questions.

Current ratio = Current assets/Current liabilities

Quick ratio = Current assets - Inventories/Current liabilities

Example:

Current assets

Cash in bank: £ 2,000

Receivables: £ 750

Inventory: £ 1,500

Current liabilities

Payables: £ 450

Loan liability for this year: £ 1,700

Current ratio: 1.98

Quick ratio: 1.28

Any number above 1 is generally good. It means that you have more assets ready at hand than you have current liabilities.

The current ratio shows the proportion between your current assets and your current liabilities, while the quick ratio is not taking into account inventories. Current assets are all the assets that your business is planning to keep for 12 months or less, in practice, this usually means cash in the bank, money that your customers owe you, inventories and possibly some office equipment of low value. Current liabilities are all the liabilities that you have to repay within the next 12 months. Calculating this proportion shows you in simple numbers whether you have more assets at hand then you do have liabilities which are falling due soon.

Let me give you an example of a situation in which this information is essential. Let's say one of your major customers has closed down their business. You predict that your revenue will fall by 40% as a result. This means significantly less cash will come into your bank account until you find new customers. If your current liabilities are high, this could mean problems with paying your suppliers or loan provider, unless you have enough cash accumulated in your bank account, or other current assets at hand which you can sell to get cash, or assets like receivables, which mean you will receive cash soon. The current ratio and quick ratio are indicators that will show you how well is your business prepared for difficulties that will come your way.

Which ratio should I choose?

All depends on the type of business you are running. Before deciding which ratio will be more useful for you, you should take into consideration these factors:

• Are your inventories food or other fast-moving consumer goods?

• Are you holding a lot of unique and specific to your business goods, that would not be easy to re-sell if need be?

• Does your inventory include a lot of old goods which have value to your business, but would be difficult to re-sell to some other business, or they would lose value significantly?

If you have answered yes to any of these questions you might consider using a quick ratio instead of current ratio. If selling your inventory would be problematic or cause a loss of value to your inventory then the current ratio would not represent the reality well and might mislead you into believing your position is better than it actually is. You should instead use the quick ratio.

To illustrate, here is an example:

Let's say you are running a designer clothes shop, in which you sell clothes of your own not yet known brand.

Current assets

Cash in bank: £ 1,000

Receivables: £ 200

Inventory: £ 4,500

Current liabilities

Payables: £ 450

Loan liability for this year: £ 1,700

Current ratio: 2.65

Quick ratio: 0.55

In this case, the ratios are dramatically different, and the reason causing the difference is the inventory. In the event of financial difficulty, the inventory would be difficult to turn into cash, and we can expect that its value will drop when trying to resell it to another business. Therefore the current ratio doesn't show the true picture, and it definitely shouldn't be used to analyze the health of your business.

If you want to learn more about what can ratios do for you, stay tuned as I will release more material about ratios soon!