NFIB

Financial Fractions
04/ 11/ 2002


So you've installed that new financial software for your business. Expense and income data are entered, and you've just produced your first profit and loss statement and balance sheet. But what do all those numbers mean? Is your company doing well or just scraping by? Are you earning an adequate return on your business investment? Does you have enough capital to cover short-term obligations? Workshop contributor Karen Bankston is here to rescue you with several financial formulas that can help you answer those questions quickly.

Start with your net income, which is derived by subtracting expenses (except interest and income taxes) from revenues. Compare your net income to previous years in business, your budget and industry averages.

Your rate of return is another key piece of data. To determine that ratio, divide net income by owner's equity, or your capital investment in the company. Let's say your company, in its third year in business, has $50,000 in assets, all from your cash investment, and net income of $36,000. That 72 percent rate of return is certainly impressive, but remember that for most sole proprietorships that rate represents both the owner's salary and a return on the investment in the business.

The true worth of the rate of return is in comparison with other years for your company and in "what if?" scenarios. How does this year's rate of return compare with last year's and with projections for next year? Is there any way to reduce assets? If your investment in the above example was $40,000, the rate of return would be 90 percent. But reducing assets might end up increasing expenses and/or reducing income. Those financial components are interrelated, and a change in one generally affects the others.

Another set of ratios can help you keep track of your company's ability to pay short-term debts when they come due. These ratios focus on working capital, the amount of money you have to run your business after you pay off your debts. Working capital is the excess of current assets over current liabilities, both of which are included on your balance sheet.

To determine the current ratio, divide current assets by current liabilities. A common rule of thumb is that a current ratio of 2:1 (two dollars of current assets for each dollar in liabilities) is acceptable, but that standard varies from business to business.

Again, this formula is most useful over time. Has your current ratio improved or deteriorated from January to September? What's behind the change? For instance, clearing out obsolete inventories might make your ratio decline without truly changing the financial condition of your business.

A tighter test of your company's ability to meet short-term debts is the quick, or acid-test, ratio. Simply divide the current assets of cash, accounts receivable and short-term investments by current liabilities. The acid-test ratio measures how much immediate cash is available to meet obligations. A low ratio is cause for concern, but a high ratio might indicate that a business has too much cash tied up in current assets that could be producing more revenue.

These and other financial ratios can transform the numbers on your income statements and balance sheets into useful data for decision-making. Use these formulas as financial short cuts to pinpoint potential problems and to experiment with likely solutions.

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