The global economic downturn has taken a toll on small businesses, and keeping your small business solvent can be tough in challenging economic times. However, there are a number of ways you can keep your ability to make debt payments and contribute to the long term growth of your business.
Your business’ solvency is essentially its ability to pay its bills and meet its obligations. Understanding solvency ratios can help you determine the overall short and long term financial health of your business. Here’s a quick look at the major solvency ratios used by businesses.
Current ratio: Your current ratio is essentially all of your current assets divided by all of your current liabilities. Most businesses will want a ratio of greater than one to one. Your current ratio is most commonly used as a measurement of whether your company is able to pay its debts as they come due. Lenders look at your current ratio to determine whether you’re a good risk to extend credit to on a short-term basis.
Debt to equity ratio: This can be determined by looking at your balance sheet and seeing what the total liabilities are compared to the stockholders equity. This amount represents the total amount of money invested by the owners of the company and the total profit of the business. Businesses with high debt to equity ratios may need to put off capital purchases and focus on lowering their debt.
Debt to assets ratio: The debt to assets ratio assesses what percent of a business’ assets are funded by debt. This number is reached by using the business’ balance sheet. To calculate the ratio, add up all current liabilities and long term debts, then do the same for all of your business’ current assets and net fixed assets. Once that’s done, divide the debt by the assets. The result will be the debt to assets ratio. For example, if your business’ total debt is $200,000, and it’s total assets are $400,000, the business debt to assets ratio is 50 percent, meaning half the company is financed through debt, and the other half is financed through investment or equity.
Quick ratio: Also known as the “acid test” ratio, this ratio takes the total current assets of your company and subtracts your current inventory and other current assets, such as deposits or prepaid expenses) and then divides the result by the total liabilities. If your quick ratio is less than 1.0, you may be a little too dependent on inventory and deposits and prepaid expenses for short term liquidity.
Day sales outstanding in trade accounts receivable: Basically, this number represents how long it takes for your company to collect on money owed to it by customers. To come up with this figure, divide your trade receivables (money due your business from sales you’ve billed for) by your average daily sales, then multiply that figure by 30. A low number in this calculation is considered good because it means your company is not burning too much capital.
Days costs of good sold outstanding in inventory: This calculation represents how long it takes your company to turn inventory into sales. This figure is reached by dividing your company’s inventory by the average monthly cost of goods sold by your company, and then multiplying the result by 30. Low numbers are good, as they represent that it doesn’t take long for your company to turn inventory into profit.
If you’re concerned about your solvency, there are a number of things you can do to improve the numbers. Obviously, you should try to sell more products or services to reduce some of these ratios, but you should also work to control costs by keeping your inventory closely aligned with your sales. Reducing debt is also important to maintaining solvency.
Key to understanding the solvency of your company is being able to decipher your balance sheet. If you’re not sure how to compile or read a balance sheet, talk to your accountant or a business mentor from your local chamber of commerce or other small business support group. They can quickly give you the tools you need to read and understand balance sheets and use the data in your decision making process.
Solvency measurements are an important tool to help you judge the health of your business, but only offer part of the picture concerning the financial health of your business. To get a fuller picture, you’ll also need to learn about liquidity measurements.
