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Toolkit for success: Ratios
 Don't
panic. This will be Math Lite.
Commercial bankers have used these simple formulas
for decades to evaluate the solvency of business owners soliciting
a loan.
Let's limit ourselves to two formulas -- the current
and quick ratios. Don't worry about ledgers and journals. Your balance
sheet has all the numbers you need.
Current ratio
The current ratio formula divides total current assets by total
current liabilities. Current assets to be included are cash on hand,
accounts receivable and marketable securities. Do not include prepaid
expenses. The answer indicates how many dollars of current assets
are available for each dollar of current liability.
Example
If you have $30,000 in current assets and $15,000 in current liabilities,
then:
Current Ratio = $30,000 / $15,000 = 2.0
In other words, you have $2 of current assets for
every $1 of current liability.
This ratio is handy to determine how well you can
meet miscellaneous losses such as bad accounts receivable or customer
refunds. It also can measure your ability to meet current obligations
and still have sufficient funds to meeting operating expenses.
Think of it this way. Let's say you're a consultant.
One of your biggest contract accounts has just declared bankruptcy.
There goes that account receivable. Do you still have enough in
cash and remaining accounts receivable to pay the bills?
In the commercial lending industry, a ratio of 2 or
better is needed for a loan to get the thumbs-up.
Quick ratio
Also called the "acid test," the quick ratio is directed toward
companies that purchase and sell inventory.
The formula is:
(Current assets minus inventory) divided by current
liability.
Example
Let's continue with the same company as above. It has $30,000 in
current assets, $15,000 in current liabilities. Now let us assume
the company has $4,000 in inventory. Remember that the value of
inventory is your cost, not the sale value.
Quick Ratio = ($30,000 - $4,000) / $15,000 = 1.73
In other words, you have $1.73 of current assets immediately
available for every $1 of current liability.
You might wonder why inventory was excluded. The reason
is that under generally accepted accounting principles, it's considered
hard to liquidate inventory if you need money very quickly.
Generally, a quick ratio below 1.0 is a bad sign.
It means you have too much invested in inventory. You either paid
too much for it or you're not doing a good enough job selling it.
Banking and trade associations periodically publish
ratio performance
results by industry. This allows you the ability to compare
your company's performance against that of like firms.
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