Dollars and Sense

Companies that go out of business today rarely  do so for a lack of sales. More often, they don’t survive because they don’t manage their cash.

With so many different methods to examine a business, we spend too little time on the most obvious information at our disposal – our financial statements. So, how can you use information from your balance sheet to help identify strengths and weaknesses of your business?

Let’s start with cash. If you remember one thing about it, remember this oft-repeated slogan – “Cash is king.” Don’t spend so much time focusing on sales that you forget it. One suggestion to help manage your cash is to use a daily reporting mechanism to provide you with information about your cash balance. For example, in our company we send a daily email to our management team that includes our current cash balance, the day’s deposits, aged accounts receivable and accounts payable balances, and upcoming cash expenditures, such as payroll, tax obligations, etc. Consistent, accurate information about your cash balances – not guesswork – should guide your decisions in managing your finances.

Your ability to manage cash is dependent on managing accounts receivables and accounts payables skillfully. Like cash, the best way to manage your receivables is to make sure you have timely information. Reviewing your receivables balance regularly is critical, and your accounting department is on the front lines of managing these collections. When it comes to collections, the squeaky wheel gets the grease. If you want to get paid, you must foster open communication with your customers regarding balances owed. Establish firm credit application policies and follow them. If you’re uncomfortable extending the credit necessary for a given job, don’t be afraid to request a deposit. Good customers will work with you in these situations.

The next necessity of a healthy balance sheet is inventory. Carrying excessive inventory, whether due to improper management of quantities or allowing for obsolescence, consumes unnecessary cash from your business. Instead, instruct your purchasing team to define proper minimum and maximum order quantities for your key inventory items and you can avoid this trap. In addition, ask your accounting team for a monthly spreadsheet detailing your inventory balances, and study it for anomalies.

As business managers, when we review financials, we tend to focus more on our assets than on our liabilities – perhaps it’s simply more pleasant to do so. However, getting a handle on liabilities is every bit as important. Your trade accounts payable picture will dictate the health of your business. If you’re constantly extending your vendors to beyond 30 to 45 days on their accounts, do you think you’re in their good graces? And this situation can bleed into your relationships with other vendors. For example, if you need a top vendor to jump through some serious hoops to expedite a shipment and you are over 60 days out with some big balances, how willing are they going to be to do that? Probably very willing – after a significant payment on their account. Reviewing your accounts payable regularly aging report is crucial when managing the cash flow. Pay particularly close attention to your biggest vendors to ensure they are being properly taken care of.

Other significant liabilities also need to be on your radar screen. For example, are you accounting for future payroll commitments in your cash management? Real and personal property tax payments often pop up only once per year, but their heft can take you by surprise. Sales tax liabilities, too, are often sizable and require planning. By using a report such as the one described earlier, you can see major cash commitments coming your way – if you arrange for that visibility. This can be very helpful in your planning.

Long-term assets, such as buildings and equipment are also important, but don’t need quite as much regular analysis from a management standpoint. Your monthly review of the financial statements should always include a brief look at these accounts to see if there are any concerns. Long-term liabilities such as notes payable are similar in the sense that nothing is going to jump up and bite you on a given day as long as you are reviewing them on a monthly basis. One note of caution with long-term notes payable: Be aware of any upcoming balloon payments that should be classified as a current liability instead of a long-term liability. If they are part of your current liabilities, they will be a more prominent part of your cash management plan.

One highly effective tool that will help you when analyzing your balance sheet accounts is the use of ratio analysis. By including a review of some basic ratios in your regular monthly financial statement reviews, you can begin to establish baselines in different areas of your business and discover anomalies as well as inconsistencies in various aspects of your business. The following are some ratios you can use when analyzing your balance sheets:

Current Ratio
Current ratio = current assets / current liabilities
The current ratio measures your company’s ability to manage its short-term cash needs. It’s calculated by dividing current assets by current liabilities, as illustrated above. If your current ratio is above 1.0, then you have enough cash and other current assets (such as accounts receivable and inventory), which will be converted to cash, to cover your short-term cash needs. Optimally, a healthy company will have a current ratio closer to 1.25 or even 1.5. This provides you with some flexibility on where you can spend your cash.

Quick Ratio
Quick ratio = quick assets
(current assets – inventory) / current liabilities
The quick ratio, also called the acid ratio, is a ratio often used by financial institutions to measure a company’s true liquidity. Because inventory takes more time to convert into cash, this ratio is a closer measure of a company’s ability to meet liabilities in the immediate future. A good quick ratio would be around 1.0. Tracking this ratio regularly will provide you with an indication of your cash position for the next week or so.

Accounts Receivable Turnover Ratio
Accounts receivable turnover ratio = sales / average accounts receivable balance
(beginning + ending accounts receivable balance / 2)
While the aging report will be your most important tool when it comes to analyzing your accounts receivable, the accounts receivable turnover ratio gives you a great indication of how effective your collection efforts are and also provides a picture of how well you are converting your sales into cash. For example, you might look at an aging report and notice that the overall accounts receivable balance went down by a good amount during a given month. That is typically a good sign. But if your overall sales went down that month by an amount larger than the drop in your accounts receivable balance, then it becomes a little bit of “fools gold” since the drop in balance has more to do with lower sales than more effective collection efforts. The turnover ratio will hedge against that by giving you a ratio that evaluates your accounts receivable balance based on overall sales. This is a great ratio to watch for recurring trends in managing your accounts receivable.

Inventory Turnover Ratio
Inventory turnover ratio = cost of goods sold / average inventory balance
(beginning + ending inventory balance / 2)
The inventory turnover ratio offers you valuable data as to the usage of your inventory. One of the most difficult things to manage in a business is inventory turnover. Too often, it becomes easy to just purchase and maintain higher-than-needed levels of inventory to avoid problems with material shortages. But that approach consumes a lot of cash from your company. This ratio, if tracked each month, will provide you with the necessary information to see if you are, in fact, managing inventory properly with a higher turnover ratio, or managing it poorly with a lower ratio.

Debt to Equity Ratio
Debt to equity ratio = total debt / shareholder’s equity
This ratio measures your company’s financial leverage by indicating the proportion of equity and debt your business is currently using to finance its assets and growth. This is a valuable ratio, but may be sufficiently reviewed once per quarter or a couple of times per year if you are not actively incurring debt.

While there are other ratios that can be used, these are some basic, straight-forward ratios that will help you as you continually evaluate your business.

I can’t overstate the importance of staying on top of your business by analyzing your balance sheet accounts with regularity. Successful business managers have accurate and timely information at their disposal, and they use it. Most of us have the information we need to manage our companies properly, but few of us use that information the way we should. With these reporting procedures and guidelines in place, you’ll be making evidence-based business decisions, and can lead your team with confidence.