Are You Outrunning the Bears?

Simple financial ratios can help you keep a close eye on your company’s health and make mid-course corrections if needed

Two guys are hiking in the Alaskan wilderness when they realize they’re being stalked by a hungry grizzly bear. One of them bends down to tighten his shoelaces, stretches and discards his backpack. His partner asks him if he seriously thinks he can outrun a bear. “No,” he replies, “but all I have to do is outrun you.”

We’ve all heard a version of this old joke. Still, there is a bit of truth to it, especially for service businesses. Can your crew outrun and out perform the competition? Is your company efficient, lean, responsive and well managed?

By regularly monitoring financial performance ratios, you can provide a cardio workout that gives your businesses endurance and speed. It’s simple. Just regularly ask yourself what bankers and savvy customers would ask.

• Have you invested enough cash to safely run daily operations?

• Do you rely too much on debt, showing lack of planning or commitment?

• Do you pay your bills on time?

• Do you collect what you’re owed in a timely manner?

Using simple performance ratios, you can calculate financial metrics from your financial statements. They work even better if you use a knowledgeable accounting professional to develop a financial monitoring system for your business. Here is a look at five metrics used in a basic system for a service business.

Current ratio

The current ratio measures working capital — your ability to meet current obligations. It measures how many dollars you have within current assets for every dollar in current liabilities. A current ratio of 2:1 ($2 available for every dollar of current liabilities) is considered healthy.

Bankers believe in the current ratio, and that’s a good reason to monitor it. Still, it presents only a vague picture of your working capital use. For example, it doesn’t show problems like too much cash invested in receivables. While it can show long-term cash utilization trends, it’s important to use other monitoring methods along with it.

Quick ratio

The quick ratio (acid test ratio) is a crisis liquidation ratio also used by bankers to analyze cash flow quality. It measures how quickly you can meet all current obligations. A quick ratio of 1:1 (one dollar of cash for every current obligation) is considered safe.

Like the current ratio, the quick ratio is most useful for trend analysis. And it doesn’t hurt to know if your business can pay all its bills in a given month, in case you would ever need to. Still, you should have other monitoring methods.

Debt-to-equity ratio

The debt-to-equity ratio shows the proportion of your business that is financed by debt and equity. The two added together, of course, equal the balance sheet value of your business assets. A 3:1 debt-to-equity ratio (somewhat highly leveraged) means you have $3 of debt for every $1 of equity, or 25 percent equity.

Bankers analyzing loan requests look for the average debt-to-equity ratio in your industry and at local norms. Even so, they will loan only within a safe range — say, between 1:1 and 3:1. At higher ratios, they will likely insist on guarantees.

That’s because high debt-to-equity means you likely have high fixed costs and a greater chance of failure in an economic downturn. Higher debt service means less cash flow for working capital and operating expenses. Lenders also generally feel low owner investment (equity) means low commitment.

Days accounts receivable

Measuring the quality of your customers is important. A sale is not a sale until you get paid. In assessing your financial condition, you should ask: What is our average days accounts receivable? The answer should closely match your payment terms.

For example, terms of 30 days from invoicing should translate to no more than 35 to 40 days accounts receivable. If it’s longer than that, you are not getting your operating cash fast enough to meet expenses and generate new sales.

It’s not necessarily bad for your days accounts receivable to be longer than your payment terms. It may simply mean one or more of your customers is an 800-pound gorilla. Big companies and government agencies are notorious for paying slowly. Courting these customers takes substantially more permanent working capital, because it takes a long time to get paid. Taking on such a customer without adequate working capital can put you out of business.

Days accounts payable

It’s also critical to measure the quality of your supplier base and maintain a reputation for paying on time. A growing business needs access to financing, and paying promptly sends a positive message to bankers and potential investors about the character of your company.

It also makes you highly desirable to suppliers — and having more than one supplier for a given item gives you a contingency in case one supplier can’t meet a delivery date. On the other hand, if you’re paying your bills too soon (your average days accounts payable is shorter than suppliers’ terms), you may be missing out on early-payment discounts.

Paying much slower than terms — in effect making suppliers provide a form of financing — makes you much less desirable.

Looking to dashboard

Beyond financial ratios, there are powerful and visually simple tools for monitoring your company’s performance. One such tool is a key performance indicator (KPI) dashboard. To develop and use such a tool, you’ll probably need a seasoned accountant and a KPI consultant.

Closely monitoring for peak performance and steady progress toward aggressive goals is one thing that sets industry leaders apart. Just a few of the metrics you can visualize with a KPI dashboard include:

• Overall sales volume per service or per customer segment

• Overall margins per service or customer segments

• Operating expenses, benchmarks and metrics

• Days accounts receivable/payable

• Service and productivity metrics

• Debt and leverage metrics

• Return on investment, equity and assets

Whether you look to dashboard tools or rely on traditional business ratios, regular checkups on the numbers can help you keep your business healthy.


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