How healthy is your business?

Today’s business environment is more volatile than ever and owners’ real-time feedback is necessary to make informed decisions. During my career, I have been fortunate to work with several successful businesses in Idaho. I often look at these companies to learn more about the habits of successful business owners.

One of the most common habits of successful owners is the simple act of monitoring their business. Just as we should go to see our doctor for an annual check-up, a business needs to be monitored on an ongoing basis to ensure that proper growth can happen. Regular monitoring also allows you to recognize negative business trends early and apply corrective action.

What information do I need to begin?

Robust financial reporting is a necessary component in monitoring your business. In order to assess your business performance, you will need to arm yourself with a few basic tools: a balance sheet, income statement, and accounts receivable and payable aging reports.

What should be monitored?

Business health can be monitored from a financial perspective in five different areas: liquidity, leverage, operations, investment and profitability. The easiest way to monitor these five areas is through the use of financial ratios. There are several ratios available that can be used, but I would suggest using five to 10 ratios at most. These ratios should be monitored on a monthly basis to ensure the company is healthy for banking, insurance, income tax and investment purposes.

What ratios can I use?

For each of the five areas, there are several ratios that can be used. Determining which ratios are used can vary by industry. End-users of the information also will determine ratios that are used. Commonly the end-user is a banker or mortgage officer. The end-user will also determine the acceptable level for each ratio.

Liquidity ratios indicate the company’s ability to meet its current obligations as they come due. The current ratio is one of the most common ratios used to measure liquidity. This ratio measures the amount of assets you have on hand that can be converted to cash within a year and compares them to the liabilities you owe that will be due within the next year.

The minimum that most end-users will accept is a 1:1 ratio. The higher the ratio, the better.

Leverage ratios refer to the solvency of the company. Debt to equity is a commonly used ratio to measure leverage. This ratio measures the total liabilities of the company and compares it to the total investment made by owners.

Most users will want this ratio to be as low as possible. A 2:1 ratio is healthy and allows for some growth.

Operations ratios demonstrate the ability of the company to convert revenue into cash. A common ratio used to measure operational efficiency is sales to receivables. This ratio compares total sales for the year to the balance of outstanding accounts receivable.

Another common ratio used is days in receivables. This ratio will tell you how many days it takes you to collect your accounts receivable on average. This number is calculated by taking 365 and dividing it by your sales to receivable ratio.

Investment ratios show the company’s ability to provide a reasonable return on the owner’s investment. Return on investment (ROI) is the most common ratio used to measure this. This ratio is calculated by dividing the company’s net income by the total investment of the owners.

Profitability ratios measure the company’s ability to earn an acceptable profit. Profit margin is a widely used ratio to measure profitability. This ratio is calculated by dividing net income by total company revenues.

Who can help?

The average business owner has access to several people who can help diagnose business issues. Every business should have a team of professionals that provide valuable insight from a variety of different disciplines. At a minimum, the areas that should be represented on your professional team are legal, banking, accounting, risk management and wealth preservation.

I also suggest that business owners look at their internal team to ensure the appropriate resources are in place. A competent bookkeeper or accounting manager will ensure that quality financial information is provided on a timely basis.

Once the team is in place, I would recommend discussing with all team members the financial ratios you will be monitoring. These professionals should be able to give you advice on what ratios you should be using and what levels those ratios should be at. Proactively working with this group will ensure that you are able to diagnose business problems as they arise and provide the resources to grow your business appropriately.

Ratios:

Current Ratio = Current Assets/Current Liabilities

Solvency Ratio = Total Liabilities/Total Investments

Operational Efficiency Ratio = Total Sales for the Year/Outstanding Accounts Receivable

Days in Receivables = 365/Sales to Receivable Ratio

Return on Investment = Net Income/Total Investment

Profit Margin = Net Income/Total Company Revenues

Lance Fenton is managing partner at Cooper Norman CPAs in Boise. For more information, visit www.coopernorman.com.

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