Previously, we’ve discussed that you can boost your profits with a few key financial Ratios that provide quick visibility into your small business. Here are the four fundamental types of ratios that encompass most of what you’ll be working with in your business:

Let’s use a liquidity measure called the “quick ratio” to see what’s going on with Sam’s bills.

Quick ratio = Current assets- inventory/Current liabilities=30,000/32,000=0.94

Ideal: 1.1

From Sam’s balance sheet, he looks at his current assets: they include \$7,000 in cash, \$10,000 in securities, \$13,000 in accounts receivable, and \$20,000 in equipment inventories. We’ll ignore inventories for now. From Sam’s balance sheet, he looks at his current liabilities: they include \$30,000 in accounts payable, \$1,000 in notes payable, and \$1,000 in provision for taxes. So at \$30,000 divided by \$32,000, Sam’s quick ratio equals 0.94 causing a cash squeeze when the target is to keep the quick ratio above 1.1 to ensure that there are more current assets than current liabilities at all times. Sam needs more cash. Maybe Sam cannot pay his bills because he’s not collecting fast enough from his customers. If that is true, his customers’ cash squeeze has just become Sam’s cash squeeze. He needs to boost his quick ratio, and fast.

Leverage Ratios: Measures the proportion of debt in your financing

Let’s use a measure called “times interest earned” to track Caroline’s leverage.

Times interest earned = Profit before taxes + interest charges/Interest charges=

160,000/40,000=4 Ideal: 8.0

From Caroline’s income statement, she looks for the profit before taxes at \$120,000, and interest charges of \$40,000. So Caroline’s times interest earned ratio equals 4, where the target is 8 times or more. The goal is to ensure that there are plenty of profits to cover the debt service. Caroline either took on too much debt or else her profits have fallen below where it is advised to carry that level of interest obligations. She needs to decrease her interest charges or boost her profits to a more comfortable and sustainable ratio.

Activity Ratios: Measures how effectively you are using your resources

Average collection period = Receivables/Sales per day=160,000/4,000=40

Ideal: 21

Mike is a construction engineer who designs complex projects and then bids on the components of the job on which his firm can compete profitably. Completing the job on time is one thing; getting paid on time is altogether a different matter. Mike sells \$1,440,000 per year, which when divided by 360 days per year translates to \$4,000 in sales per day. His receivables are listed on his balance sheet at \$160,000. In his contract terms, Mike expects to be paid with 21 days. Let’s use a measure called “average collection period” to track this activity measure. Mike’s customers are taking almost twice as long to pay him as stipulated in his contracts. Mike needs to accelerate his collections, add more milestones, or perhaps collect down payments on some jobs.

Profitability Ratios: Measures returns on sales and investments

Profit margin = Net profit after taxes/Sales=150,000/1,500,000=10%

Ideal: 12%

Alice runs a specialized packaging company that ships sales booth signage, equipment, and information materials for local hi-tech firms. Her business is doing quite well now that she has added sequential drop-shipments to her mix of offerings. Rather than shipping materials back to HQ, they can be stored temporarily then forwarded directly to the next convention.  Alice sells \$1,500,000 per year. Her net profit after taxes is \$150,000. Let’s use a ratio called “profit margin” to track this profitability measure. As it turns out, Alice is underperforming her target profit margin by two percent. Options include: bundling offerings, new offerings, cutting costs, increasing prices, and adding partners, among others. Alice is currently beating the industry average of 8%, yet she is always looking for ways to grow.

Even if you hate numbers, you can proceed through your business operation systematically to review what is actually happening vs. what you thought was happening.

Remember – Just Say No to the Status Quo TM