By Ronald S. Niemaszyk
Ralph is the owner of a small answering service and one of my favorite clients. One day, when I was in his office, he dropped a report on the table in front of me. With great fear in his voice, he said, “look how much money I’m losing!” The report was a bank statement showing cash inflows and outflows for a one-month period. Given the fact that the cash outflows where larger then the inflows, I easily understood his cause for concern. After looking a little closer, it became quite obvious that some timing issues were distorting the financial picture.
This kind of a situation it not unique to Ralph. It’s obvious that every small business owner cannot be an accountant. Time and again, I hear my clients judge the financial health of their business by how much cash they have in the bank. You often hear accountants say “cash is king”. While cash balance is an important determinant of financial strength (or health) at any given point in time, it isn’t necessarily meaningful as to where a business has been or where it’s going. In addition to the balance in your checking account, there are two other tools that can assist in assessing the financial health of your business.
Budgeting/Forecasting: Our practice prefers looking at a twelve-month budget period. We populate the budget with estimates or projections and when actual bills and revenues are received, the budget is updated accordingly. If the business has a substantial cash balance, or reserve, we usually compile the numbers to produce monthly totals. As the cash balances decrease, we look at the numbers on a weekly basis, and in the worst case scenarios we have the client provide daily updates. By forcing the client to look months ahead they are able to better forecast where problems could arise. In most cases, it is easier to deal with financial issues before they become problems.
Ratio Analysis: By running numbers from your financial statements through a variety of mathematical equations, you can also gain valuable information that may help you determine where attention should be focused or action is needed. For many industries, we are able to compare a client’s ratios to industry averages which are published by trade groups or other sources. Unfortunately, we do not have reliable industry data for the teleservice industry. (However, with your assistance, this is something we hope to compile over the upcoming months.) For now, we can talk about service businesses in general, and it is always helpful to track these ratios for a single company over time (the more time periods the better). For most of our clients, we compile the data on a quarterly basis. By putting the data on a spreadsheet and adding a new column for each new quarter, we are able to see normal levels develop and inevitably, red flags arise. Sometimes these anomalies indicate a problem that needs attention; in some cases they are simply caused by timing errors.
Here are some worthwhile ratios to watch:
Days Receivable Outstanding = Total Receivables / Average Daily Sales
The lower the number the better. This is a good number to track midway through the billing cycle. An up-tick in this figure at the same point in the monthly billing cycle will highlight whether your collections need more attention. This is a powerful figure in helping determine how the slowing economy is impacting your receivables. If you are midway through a monthly billing cycle, the number should be between 10 to 15 days. (To determine “average daily sales,” take your monthly billing and divide by the number of days in the month.)
Current Ratio = Current Assets / Current Liabilities
This is the primary ratio used to determine a company’s ability to meet obligations. A current ratio of less than one is cause for concern, while the ratio for top performing companies will often be three or higher.
Return on Equity = Net Profit Before Tax / Total Owners Equity
This figure is important because it helps you to look at your business like any other investment. You should have a target rate of return for your business, just as you should for all of your investments. Established service businesses that require an investment in equipment, like teleservice companies and call centers, will usually provide a return on equity of 5 to 15%. The figure for top performers ranges from 25 to 40%.
It should be pointed out that in a small business, ratios could be easily affected by all kinds of issues. One-time charges, timing, accounting errors, or inconsistent accounting treatment over differing time periods may make the data hard to interpret. One ratio at a single point in time may give you insight, but the real power comes from compiling the data over long periods of time. Once we gather data to compute industry averages, it will also be worthwhile to see how your ratios compare to other companies in the industry. Please consider participating in our upcoming financial statement study.
Ronald S. Niemaszyk is a Principal in Jordan/Patke & Associates, a certified public accounting firm in Deerfield, IL. He can be reached at 847-382-1627 or email@example.com.
[From Connection Magazine – March 2002]