A Little Financial Knowledge

Understanding your numbers can yield Big Results

Is your business successful?  How would you know?

Small business owners, their managers, and even bookkeepers do not begin their careers as financial analysts, and why should they? Financial data does not build anything, nor sell anything. Furthermore, how excited do you get when you hear terminology like asset, liability, quick ratio, gross margin, productivity, and efficiency? (A humorist might define “gross margin” as ugly, barely legible notes scrawled on the edge of a financial statement). As a business owner, basic financial knowledge can be very exciting, especially when you realize that it provides the answers that help you measure and fine tune the success of your company. This post defines a short list of terms, definitions, and their daily use that you’ll find very powerful.

Current Ratio and Quick Ratio: These ratios, or relationships between the things we own (assets), and the things we owe (liabilities), give us a snapshot of the “current” health of our company. You want to have more than enough current assets to pay for your current liabilities. Current assets equal your cash and other assets that are readily converted to cash, such as trade receivables and inventory. When compared to current liabilities, such as payroll, taxes, and trade payables that are due “currently” or “quickly,” a healthy company will have at least twice the amount in current assets as it owes in current liabilities. Here’s an example:

Current Ratio (Goal => 2.0)
Cash $20,000 + Receivables $10,000 + Inventory $30,000 = Current Assets (e.g. $60,000)Payroll + Taxes + Payables = Current Liabilities (e.g. $30,000)
The Current Ratio is $60,000 vs. $30,000, which is 2:1, or most often written as 2.0.

The Quick Ratio is the same, except that inventory is removed from the equation because it converts to cash more slowly and, not insignificantly, is required for daily operations.  It looks like this:

Quick Ratio (Goal => 1.5)
Cash $20,000 + Receivables $10,000 = Current Assets (e.g. $30,000)
Payroll + Taxes + Payables = Current Liabilities (e.g. $30,000) Here, the Quick Ratio of $30,000 of assets vs. $30,000 owed is 1:1, or simply 1.0. While this indicates that the current bills can be paid, there is nothing extra. Reserves would be better!

Gross Margin: This is simply the difference between the sales price of your product and the cost to produce it, expressed as a percent or “margin.” Therefore, a product selling for $500, which costs $200 to produce, gives you a gross profit of $300, or 60% of the $500 sales price. Your “gross margin” can then be measured against your company’s requirements, the margins of others in your industry, and best-practice benchmarks.

Productivity: This one is really easy, although it is often confused with “efficiency.” Productivity is simply computed as the number of hours “worked” vs. the number of hours “available” to work. Therefore, an employee who works (actual production) 6 hours in a typical 8-hour workday is 75% productive. The remaining 25% (2 hours) are lost and cannot be replaced.

Efficiency: This equals the time billed as compared to the time worked and is also measured as a percentage. When a job that allows 2.0 hours to be billed to a customer is completed in 1.6 hours because of the high skill level of an employee, we see that 2.0 hours were sold within 1.5 hours of time spent. The efficiency rate (2.0 divided by 1.5) is 125%.

Begin using these four metrics to build your financial analysis skills and see if their use doesn’t also help you build an even more successful business.