Last time we talked about the Balance Sheet structure but did you know that there are some quick calculations that you can do to check the health of your business?
Hi this is Judi Otton with GrowthCast and today I’m going to give you three of those quick calculations. But before we start you may want a visual description of this so grab that here (Subscribe to our Newsletter). It will help you understand what I’m talking about.
The first calculation I want to talk about is called the Quick Ratio. It measures a company’s ability to pay its Current Liabilities or current obligations. The way that you calculate it is Current Assets minus Inventory divided by Current Liabilities. A higher result is better. Certainly, you want it to be higher than one which means that you have the liquid assets to pay any of the liabilities that you have. It’s similar to something called the Current Ratio but it’s a little bit more conservative because it eliminates assets that are not easily and quickly turned into cash.
The second calculation I want to talk about is Working Capital. Now, many business owners think working capital is the money that they have in their checking accounts. That’s not really true because there are other things going on in your business meaning you have other liabilities that you need to pay. So the true definition of Working Capital is Current Assets minus Current Liabilities meaning if you were to pay all of your Current Liabilities today, this is what you have left over. This is a great quick measurement of a company’s liquidity and financial health. Obviously, it should be greater than zero. It’s money that you’re using to fund your operations and to fund your future growth. If it’s less than zero, you run the risk of not being able to meet your current obligations. But with this one, it also can be too high. We’ve heard about a lot of companies these days with lots of cash on the books and this is related to this. It means that it could mean that you have too much inventory or you’re not investing your excess cash very well.
The third calculation that I want to talk about is the Debt to Equity Ratio and this is calculated as Total Liabilities divided by Owners Equity. We want this to be less than one. We want to have fewer outside liabilities than we have equity. This is important if you’re trying to borrow money because bankers are not going to lend you money if your Debt to Equity Ratio is one or greater, You may have heard that bankers want you to have skin in the game. That’s what this means. They want you to be invested in your company as well.
So those are three quick calculations that you can do on the Balance Sheet, grab that visual description (Subscribe to our Newsletter). So you can see exactly how these calculations are made and I’ll be back next time with another Fiscal Fitness Tip of the Week