Crunching the Numbers

A few simple calculations will tell you if your business is on the rise or headed for the edge of a cliff.

Crunching the Numbers

istock photo

If you’ve ever read an investment analyst’s report on a stock, you’ve probably seen references to various calculations that the writer used to justify why the company is a good or bad investment.

What you may not realize is that those same calculations can tell you a lot about your own business. These numbers — a set of simple ratios — can give you a quick snapshot of the health of your business, just like the one your doctor gets by checking your weight, blood pressure, blood sugar and cholesterol.

Your guide to these numbers is Don Shultz, controller for Newcomb Marketing Solutions in Michigan City, Ind., and a member of the Leaders’ Resource Network.


First, a quick review of some terms.

Net income is what your business makes after taxes and expenses.

Assets are everything your business owns, including the value of your receivables (invoices sent but not yet paid). Current assets include cash; items you can turn into cash within a year, including receivables and inventory; and items that are used up within a year, such as prepaid expenses. They don’t include fixed assets like vehicles or office equipment.

Liabilities are everything your business owes: long-term and short-term debt and unpaid bills. Current liabilities are those that come due in the next 12 months.

Capital stock is the money you started with to buy or launch the business.

Retained earnings is what you have left at the end of the year after paying all bills, including your salary and distributions. This number accumulates from year to year.

Shareholders equity is the net worth of your company. It consists of your capital stock, added to your retained earnings, less any distributions to shareholders over time. Another way to think of shareholders’ equity is assets minus liabilities equals shareholders’ equity.

Every one of these numbers should be readily available if you keep your books up regularly. While the individual numbers may tell you certain things, it’s far more revealing to put them together. A series of ratios can give you a powerful microscope to study your business and even see what might be around the corner.

Doing the Math

The first of these is the current ratio — your current assets divided by your current liabilities. “At the very least, you want to have your current assets able to satisfy your current liabilities,” says Shultz. That would be a ratio of 1 to 1 — but that by itself isn’t very healthy. To put it simply, it would mean you could pay all your current liabilities by cashing out your current assets, and you’d have nothing left over.

By comparison, if you had, say, a current ratio of 1.8 to 1, you could cover those liabilities and still have a healthy amount of cash. Then there’s the downside. “If that ratio is less than 1 to 1, it says you’re going to be in trouble meeting your obligations,” says Shultz. “Either you’re low on cash or you’re low on receivables. You’re going to be hurting for cash to meet your liabilities.”

More specifically, if the ratio gets too low, at the end of a month you could find yourself unable to pay bills on time or meet your payroll. This of course is called poor cash flow, and almost nothing is more damaging to a business.

A similar measure is the quick ratio, which looks at your cash on hand and your accounts receivable. It excludes anything you would have to sell (such as inventory) to produce cash. Those “quick assets” are divided by your current liabilities.

Again, a ratio of 1 means at least you won’t owe anything if you cash out, but the greater the number, the better off you are, and a ratio of less than 1 is a danger sign.

Other Ratios

Unlike the current or quick ratios, the other ratios to study will almost certainly be less than 1, even for a healthy business.

The first of these is your return on assets (ROA) — your net income from whatever period is under study divided by your total assets. Suppose your assets total $400,000 and your net income for a given month is $10,000. Your ROA for the month will be 0.025. Assuming one month is like any other, your net income for the year is $120,000, and your ROA for the year is 0.3. That may sound tiny, but for ROA that’s a very respectable number.

ROA is a quick measure of how efficiently your business uses its assets. If you can bring that number up from month to month or year to year, it shows you’re working smarter with what you’ve got. Of course, there are times when it will plunge, such as when you buy pricey new equipment. Ideally, though, you’ll bring the ROA back up quickly as the new equipment helps you generate more income.

Closely related is return on investment (ROI). This is your net income divided by your shareholder’s equity. Unless you have absolutely no liabilities, your equity will be smaller than your assets, so the ROI will be larger than the ROA. Continuing with our previous example, let’s suppose $200,000 in liabilities, leaving a shareholder’s equity of $200,000. The ROA for the year ($120,000 divided by $200,000) is 0.6 — again, a very healthy number. Once again, this number should grow over time if you’re operating efficiently. If it drops steadily, that’s a sign your business is becoming less profitable, and if it hits zero or goes negative, you’re in real trouble.

Finally, there’s the debt to equity ratio — your total liabilities divided by your shareholder’s equity. The higher that number, the more you’ve relied on debt to finance the growth of your business. A lower number means you’ve been more cautious.

One rule of thumb used by many analysts is that this ratio should be below 30 percent. If it’s higher than that, you could be in danger of carrying more debt than the business can support.

A Monthly Habit

Shultz recommends checking these numbers every month. ROI and ROA will change slowly; debt to equity might not change at all for a long time, then take a sudden spike upward if you buy a new vehicle or finance new office space. If the quick and current ratios remain steady from month to month, that shows steady business; fluctuations can reveal seasonal ups and downs.

What you’re ultimately looking for are trends: Are you getting worse or better? If you’re getting better, great! If you’re getting worse — for instance, if the quick and current ratios move closer to or even below 1 — maybe it’s time to find ways to boost income and cut expenses.

Stay in touch with your creditors and renegotiate terms if you have to. “You probably have a credit line at the bank to help you get over a short-term crunch,” Shultz notes. But longer-lasting troubles require more systematic fixes.

If you keep good books, it shouldn’t take you long to get comfortable with these very simple numbers. And while it may sound like drudgery, just knowing that these are the same things those Wall Street analysts track should be an inspiration. After all, however large or small, your business is the most important investment you’ll ever make.



Comments on this site are submitted by users and are not endorsed by nor do they reflect the views or opinions of COLE Publishing, Inc. Comments are moderated before being posted.