With 2013 nearing its end, it’s time for your business to start planning ahead for next year. However, before you start brainstorming, you need to bust out the books and check where you stand financially. For some small businesses, this can be a breeze, but for others, this can cause some headaches. Thankfully, if you know what to look for, an analysis of your balance sheet can provide valuable insights into your business’ financial health. Before laying out your business development plans for 2014, make sure you scrutinize these 3 things from your balance sheet.
*Note: We will be referencing the balance sheet below in our examples.
When looking over your balance sheet, one of the most important metrics to track is your business’ current ratio. With the current ratio, you can calculate whether or not your business has enough resources to pay its short-term debt over the course of the next 12 months. In other words, the current ratio tells you if you can even pay your bills or not. To calculate the current ratio, this formula is used:
Current Ratio = Current Assets / Current Liabilities
When digging into the current ratio it’s important to remember that current assets are short-term assets that are expected to be converted into cash within one year. Similarly, current liabilities are short-term liabilities that are expected to be paid within one year. With that in mind, you always want your current ratio to be greater than 1. Looking at the example above, we find that they have a current ratio of 1.19 : 1 ($27,968 / $23,439 = 1.19). So, for every dollar in current liabilities, there is $1.19 in assets.
When evaluating your current ratio for future plans, it’s important to keep a few things in mind. First, not every ratio that’s near or below 1 is bad. If your company has an inventory that can quickly be turned into cash, then it just means your assets are more liquid. On the other hand, a high ratio isn’t necessarily good either. If your current ratio is near 3 or 4 then you’re probably doing a bad job of investing your cash.
Total Debt Ratio
Using the total debt ratio, you can do exactly what you think you’d be able to: figure out how much your business is in debt. Easy enough, right? To figure out your total debt ratio, use this formula:
Total Debt Ratio = Total Liabilities / Total Assets
In a previous blog post, we explained that debt could be a normal part of a healthy business. However, when examining your business’ total debt ratio, you never want your ratio to be greater than 1. Looking at the example above, if we were to calculate their total debt ratio, we’d find that they have a healthy ratio of .77: 1 ($36,839 / $47,550 = .77). So, for every 77 cents of debt, the company has a dollar in assets to cover it.
Quick Test Ratio (a.k.a. Acid Test or Liquidity Ratio)
Despite its name, the quick test ratio is actually one of the more detailed tests of a company’s financial health and liquidity. However, it is an important test because it measures the dollar amount of liquid assets available to pay off current liabilities. To calculate the quick test ratio, use this formula:
Quick Test Ratio = (Current Assets – Inventories) / Current Liabilities
When examining the quick test ratio, you always want it to be greater than 1; and the higher the quick test ratio, the better liquidity of your assets. When looking at the example above, we see that they have a quick test ratio of 1.13 : 1 (($27,968 – $1,382) / $23,439 = 1.13). This means that for every dollar in current liabilities, they have $1.13 in liquid assets to cover it.
When evaluating your balance sheet, there are several metrics you can check to help get a better understanding of your business’ current bill of health. When planning your business’ strategy for the year ahead, always check these 3 ratios to see where you are now, where you’ll be in 12 months, and consider the changes your business needs to make so that your ratios line up with your goals. However, it’s important to remember to not get too caught up in the calculations. The first thing you should always look for when examining your balance sheet is an improvement from the year before. That is truly the most important metric.
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