Can You Walk the Walk If You Cant Talk the Talk? Improve Your Financial Vocabulary
Accounting is the language of business. Getting more information from your accountant than just pages of numbers in the form of monthly reports requires that you know the language. For many owners, that means acquiring a new vocabulary complete with terms like "gross margin," "key performance ratio," and "break-even analysis."
Unfortunately, many business owners are intimidated by the language or choose to ignore it altogether. They ignore the financial performance of their company, delegate it to an employee, or outsource it. Understanding the fundamental financial concepts gives owners a much better chance of prospering in todays challenging economic environment.
Essential Terms
In business, cash is king. If you have it, youre winning. Positive cash flow and debt coverage ratio are two key concepts to master when managing your financial health. Positive cash flow results when the money you receive from your customers exceeds the expenses you pay to run the business. This is different from the profit or loss you see on your income statement because receiving money and paying bills is not the same as revenues and expenses. Anyone who has been unable to collect on an invoice understands the difference.
From time to time, businesses borrow money to grow or to cover shortages in positive cash flow. Your ability to negotiate favorable terms will depend on the lenders confidence in your ability to repay the loan. The debt coverage ratio is a measurement of the companys ability to pay its monthly bills. Investors look for companies that are profitable enough to provide a return on their investment (ROI). Lenders, on the other hand, use a companys debt coverage ratio to decide whether to make a new loan or negotiate an extension of an existing note.
This is how a debt coverage ratio works: if a company has one dollar available to pay one dollar of debt, the debt coverage ratio is 1:1. Most lenders require a debt coverage ratio closer to 1.25:1, meaning that they expect $1.25 of earnings available to pay every $1 of debt. A minimum debt coverage ratio often becomes a covenant, or promise, of the loan and is included in the loan documents. Even if you are making your payments, if your debt coverage ratio falls below the required ratio, you will be in technical default on your loan and the lender can call the note.
Liquidity Ratios
Liquidity refers to the ability to cover short-term payment obligations from your available assets. Available assets are generally considered cash and cash equivalents and other assets that are readily convertible to cash. Looking at a balance sheet, these are generally listed under Current Assets. The obligations that are considered are listed under Current Liabilities.
The two ratios that lenders look at are the current ratio and the quick ratio. The current ratio is computed by dividing the current assets by the current liabilities. A ratio of 2 or greater indicates that there is sufficient liquidity to cover current obligations. Current assets include non-cash items such as inventory. The current ratio assumes that a business could sell its non-cash current assets quickly and at their book value if needed to pay bills. This is not always possible. The quick ratio is computed after excluding many of the non-cash items that are included in current assets. It is a better estimate of the funds available to pay your current bills. A quick ration over 1 is desirable.
These ratios are often part of the covenants lenders include in financing documents. Failure to maintain the minimum required ratios is a technical loan default and lenders will expect quick action to cure the default. These ratios can be improved by decreasing current liabilities or increasing current assets. Selling unused long-term assets for cash to pay off current liabilities or obtaining a long-term loan to pay current bills will both increase liquidity ratios. Speeding up collection of accounts receivable, on the other hand, will have no effect on liquidity ratios. Accounts receivable and cash are both current assets so you are just converting one current asset for another. The ratio will remain the same.
Break-even and Days Sales Outstanding
A companys break-even point is the amount of revenues required to meet all fixed and variable expenses. Once break-even is reached, revenues only need to cover the additional variable costs with any remaining funds going to profit. Technically, until a company reaches its break-even, it hasnt made a profit.
A low break-even point is best. A business lowers its break-even by reducing fixed expenses, reducing direct costs, or increasing the selling price. Understanding break-even is necessary to develop appropriate discounting programs and strategic pricing plans.
Another important financial concept for any business that extends credit to its customers is the accounts receivable days sales outstanding. This tool measures the amount of time it takes to get paid for the work you do. The longer it takes to collect your receivables the higher the probability that youll write off uncollectable debt. The days sales outstanding tells lenders and investors how effective the company is at managing cash flows, credit, and collections.
Conclusion
Many business owners never get beyond reviewing the financial statements prepared by their accountants. These reports are important, but only as a feedback mechanism for their past performance. Accountants prepare these statements primarily for income tax purposes. Business owners will get the best value from these statements when they know how to use the historical data to predict future performance by computing important ratios and indicators. Then, you can actively guide your efforts to achieve your long-term goals.
? Copyright 2009. Bill Gschwind. inPURSUIT Consulting, LLC.