Small Business Questions & Answers


Filed under Finance

Ask About Business Ratios -- Part One

by Ratio Rookie | May 20, 2012

Subject :Accounting and Finances

Dear Toolkit,

I've heard that calculating "business ratios" from my financial statements would be helpful in running my store. What I haven't heard is why. Can you enlighten me?


Ratio Rookie

Dear Rookie,

Just as a baseball coach looks to batting averages and ERAs to help him manage his players into a winning team, you can look to the numbers in your business to help you manage your resources into a successful operation.

And as in baseball, business has dozens of varieties of "stats" that are used as decision-making management tools—and for most businesses, there are four major groups of statistics that are most commonly used. These four categories are (1) liquidity ratios, (2) efficiency ratios, (3) profitability ratios, and (4) solvency ratios.

Liquidity ratios are used to determine how quickly a business can generate cash. Lenders love these ratios as they measure your ability to pay them back (or not, as the case may be.) Liquidity ratios are sometimes called "working capital" ratios, since that's what they actually measure. There are two basic liquidity ratios—the current ratio and the quick ratio.

The current ratio measures your short-term solvency by comparing your current assets with your current liabilities. If you have current assets of $2—half in your checking account plus half in inventory—and current liabilities of $1 in accounts payable, your current ratio is 2 to 1 (2:1). . .which is just about perfect as current ratios go. You could pay your bills and still have liquid assets (in this case, cash) on hand.

The quick ratio, sometimes known as the Acid Test, is basically the same as the current ratio, except that it eliminates your "maybe-not-so-quickly-liquidated" current assets from the mix. Your inventory, for example, may take longer to sell off than you have been optimistically estimating. So, if we take our current ratio (above) and remove the inventory, that leaves us with the ingredients for our quick ratio—$1 in cash and $1 in accounts payable, yielding a quick ratio of 1 to 1 (1:1). . .which is also just about perfect as quick ratios go. You could still pay your bills even if the inventory doesn't sell.

In Part Two of About Business Ratios, we'll continue our examination of the remaining three categories of ratios. In the meantime, do some homework and take a look at your own balance sheets and see what your current and quick ratios have been for the past few periods (years, quarters or months.) Remember that there might be some factors distorting your ratios as compared to themselves or to the norms. Over a period of time, inflation (that dirty word we begin to see in the news lately) can wreak havoc with your periodic ratio comparisons. Another distorting factor might be caused by changes in accounting methods. Keep these possible variables in mind if you are doing ratio analysis over a longer period of time.