I specialize in solving urgent business financial problems. Interestingly, on most of my crisis assignments, management and investors often say one or both of the following:
- They didn't see the problems coming.
- Had they fully understood the consequences of their actions, they would have done things differently.
Many of the crisis situations I am brought in to fix could have been foreseen or avoided with the consistent application of some basic, but essential, financial management tools.
In my May newsletter
, I discussed one of these tools - a rolling 13-week cash flow
for spotting and managing liquidity problems.But, what to do when a cash flow forecast is not available? Today, we take a look at financial ratio analysis
, a tool for spotting liquidity risks by looking at both historical and projected financials.
Before we dive in, however, remember that liquidity is not the same as solvency.
Liquidity is being able to pay bills on time as they come due. Solvency is having assets exceed liabilities. And while insolvent companies eventually face liquidity problems (Detroit is a good example), solvent companies can face them as well.
Keep in mind too that while liquidity ratios do require some understanding of financial statements, only a rudimentary understanding is needed. So read on, even if you don't particularly enjoy looking under the financial hood. CURRENT RATIO
The current ratio is simply current assets on the balance sheet divided by current liabilities.
The balance sheet should break out and identify current assets and current liabilities and subtotal them, so this basic ratio is easy to calculate, even for financial statement novices. Current assets
are typically those associated with working capital such as inventory and accounts receivables. Current liabilities
are those liabilities that are due within a year, and include accounts payable, accrued payroll and so forth. In theory, the lower the current ratio, the worse things are.
That said, this ratio fundamentally assumes that all current assets can be easily converted to cash to pay current liabilities. In truth, a company with some illiquid current assets (out of season seasonal inventory, or deferred taxes, for example) is in worse shape than a company with lots of liquid assets. QUICK RATIO
The Quick Ratio, sometimes called the "acid-test ratio," takes into account the fact that some current assets can be converted to cash more easily than others.
For the numerator, instead of all
current assets (as used in the Current Ratio), the Quick Ratio uses only cash and equivalents, short-term investments and accounts receivables
. These are the "quickest" assets that can be turned into cash to pay bills.
The Quick Ratio also has its shortcomings. In particular, some accounts receivables can be converted to cash more quickly than others. For example, it takes longer to convert accounts receivables to cash in an industry with 90-day terms than it does in one with 10-day terms. In addition, some receivables may be subject to offset by the company's own purchases from their customer. The list goes on. CASH RATIO
The Cash Ratio takes into account the aforementioned shortfalls in the Quick Ratio. As its name suggests, this ratio considers only cash (broadly defined as cash, cash equivalents and invested funds) in its numerator,
again, with liabilities in its denominator.
Not surprisingly, most companies don't have enough cash and near cash to cover current liabilities, so the Cash Ratio is rarely above 1 and therefore not as useful as the others. In fact, a high cash ratio often indicates there is too much
cash on the balance sheet. CASH CONVERSION CYCLE
The cash conversion cycle is not a true ratio, as it is not measured as a percent but rather, in numbers of days.
In this case, it is the number of days to take inventory, sell it and collect the receivables, less the days the company uses vendors money before it pays vendors.
|Cash Conversion Cycle||= DIO +DSO - DPO|
|DIO = Days Inventory Outstanding|
|DSO = Days Sales Outstanding|
|DPO = Days Payables Outstanding|
I'll spare you too much detail, other than to suggest that a rising trend in CCC days is not a good sign for liquidity.
Note, by the way, the importance played by an increase in accounts payable - as it rises, inventory and accounts receivable become less of a problem. However, watch for sudden changes in the components. What should be a good trend may really be a warning sign. For example, days of payables increasing because there is not enough liquidity to pay vendors, or days of inventory decreasing because vendors are not shipping for lack of payment, are signs of financial distress. These ratios can be used in a number of helpful ways:
- Track them for your business over time and calculate them when plans, budgets or projections are done. Obviously, improving ratios are better than the alternative (remember that seasonal patterns may have an impact).
- These measures are used by creditors to evaluate debtors. You can use them to track your customers where appropriate and to see how creditors, particularly banks, view you.
There are some caveats to using these ratios, however:
- Use them to compare your business with competitors. Use published financials for public companies. For private companies, industry-specific ratios are often available from various service providers.
- Always use judgment. Ratios should not be used alone to assess liquidity nor should one liquidity ratio be used in isolation of other ratios.
- When using ratios to compare companies, also consider differences in accounting methods, such as LIFO vs. FIFO for inventory. Then compare the homogeneity of operating units. Using ratios to compare a company in one business with one in several different businesses is often of limited value.
Running out of the cash needed to operate your business is never a good thing. Being blindsided by a crisis of this type is much, much worse.
- The use of liquidity ratios is not a substitute for a good 13-week cash flow forecast.
Take the time to understand and apply these four simple ratios and you'll reduce the likelihood of your company running into unexpected liquidity problems.