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Pivotal Liquidity Metrics to Help You Avoid Insolvency

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This post is part of a series called Key Metrics Every Business Should Track.
How to Measure Your Business's Profitability
Make Your Business More Efficient By Tracking These Numbers

In the first tutorial in our series on keymetrics your business needs to track, we looked at profitability metrics.

But profitable companies can still run into serious problems if they don’t keep a close eye on their liquidity, i.e. their ability to cover all upcoming expenses without having to sell off assets.

So in this tutorial, you’re going to learn four different ways of measuring the liquidity of your business. You’ll see why each one is important, how to calculate it, and what the results tell you about your business. You’ll also find out how to improve the results in the future.

This week, many of the numbers we’re using come from the balance sheet, so if you’re not sure what any of them are or where to find them, you can refer to our tutorial on reading a balance sheet.

1. Quick Ratio

Why It’s Important

Another name for the Quick Ratio is the “Acid Test Ratio,” which should give you an idea of how critical it is. This ratio measures your ability to pay off your short-term debts and other liabilities using the money in your bank account and other easily accessible funds. If it dips too low, you’ll be in danger of defaulting on your obligations, and perhaps even being forced to declare bankruptcy.

How to Calculate It

The calculation is quite simple, and involves three lines taken straight from your business’s balance sheet:

Quick Ratio = (Current Assets – Inventory) / (Current Liabilities)

If we look at the General Motors 2013 balance sheet, for example, we see that the company had $81.5 billion current assets, $14.0 billion inventory, and $62.4 billion current liabilities. So the calculation would be:

Quick Ratio = (81.5 – 14.0) / (62.4) = 1.08

How to Evaluate It

Generally you’re looking for a number greater than 1, indicating that you can access enough money to cover your short-term liabilities. GM passes the acid test, as you can see. The higher the better in terms of avoiding insolvency, although if the number gets too high, it raises the question of why you have so much cash sitting around when you could be investing it in your business.

You may be wondering why we subtract inventory. The reason is that although inventory is listed as a current asset, generally it’s hard to convert it to cash quickly. For example, GM has $14 billion worth of cars waiting to be sold, but it can’t access that money immediately. If it needed money urgently to pay off a debt, it would have to look elsewhere.

If your business is able to sell off inventory very quickly, you might want to use the current ratio, which is simply:

Current Ratio = Current Assets / Current Liabilities

The quick ratio is the more conservative measure, and it’s generally best to err on the side of caution when you’re measuring your ability to pay your debts and stay in business. But the current ratio is useful if you’re confident that you can convert your inventory quickly to cash if the need arises.

How to Improve It

If you see your quick ratio starting to decline, and particularly if you see it dip below 1, it’s important to take action. See if any of your planned expenditures can be delayed, or if you can renegotiate terms with any of your suppliers.

Or you could look at ways to bring cash into your business more quickly, such as offering special discounts to boost sales, speeding up invoicing, or as a last resort, selling off assets. For more ideas, see our tutorial on managing cash flow.

2. Interest Coverage Ratio

Why It’s Important

With the quick ratio, we were looking at your company’s ability to cover all of its obligations. But sometimes it’s useful to focus in particularly on whether you can generate enough profits to service your debt. After all, it’s the inability to make debt payments that often triggers serious problems for a business and leads to bankruptcy. It’s just like in your personal life: You can delay, reduce or wriggle out of most expenses, but things get really ugly when you start missing mortgage payments or getting behind on paying off your credit cards, auto loans and other debt.

How to Calculate It

This time we’re looking for our numbers on the income statement. The formula for calculating interest coverage ratio is:

Interest Coverage Ratio = Earnings Before Interest and Tax / Interest Expense

Let’s use financial giant Citigroup as an example this time. Its 2013 income statement shows Earnings Before Interest and Tax (EBIT) of $35.7 billion and interest expense of $16.2 billion. So its interest coverage ratio is:

Interest Coverage Ratio = 35.7 / 16.2 = 2.2

How to Evaluate It

The higher the better with this ratio. You definitely want to see a number higher than 1, and preferably 1.5 and above. That indicates that the profits from the business are at least enough to keep paying the interest you owe. Given that the idea is to do more with your profits than simply pay off debt interest, ideally you’ll want the number to be significantly higher. Citigroup’s ratio of 2.2 is pretty healthy.

Keep in mind, also, that right now we’re in a period of low interest rates. If interest rates start to rise in the next few years, your interest expenses could rise sharply too. If you have a variable-rate loan currently at 4% interest, for example, and the rate climbs to 8%, then your interest expense doubles. So it’s important to have enough coverage not just for your current payments, but also for any future increases you anticipate.

How to Improve It

There are two variables here: earnings, and interest expense. To minimize interest expense, try to limit how much debt you take on in your business, and try to pay down your existing debts or refinance to a lower rate. If funds are tight, some of the options we looked at in our series on funding a business might help you raise more money from equity rather than debt.

The other option is to look at ways to boost your earnings. If you can cut costs in other areas of your business or boost revenue, you’ll have more money available to cover your debts.

3. Days Sales Outstanding

Why It’s Important

One good way of improving liquidity in your business is to ensure that when you make a sale, your customer pays as soon as possible. Days sales outstanding (DSO) is a measure of how quickly you’re able to convert a sale into cash in the bank.

How to Calculate It

This time we’re going to combine a number from the income statement with one from the balance sheet. The formula is:

DSO = Accounts Receivable / Average Daily Sales

Accounts receivable, sometimes called “net receivables,” is the line on your balance sheet that shows the total amount that customers owe to you for goods or services you’ve sold. The average daily sales, of course, is just the annual sales divided by 365. Or if you’re looking at it over a shorter period, it could be monthly sales divided by 30.

We’ll stick with annual figures for this example. Canon’s 2013 balance sheet shows accounts receivable of $5.8 billion, and its total revenue for the year was $35.5 billion, so we plug in those numbers and get:

DSO = 5.8 / (35.5 / 365) = 5.8 / 0.097 = 60 days

How to Evaluate It

The result shows the average number of days it takes your customers to pay you. In Canon’s case, it takes 60 days on average for a buyer of its printers and other goods to make payment.

In general, a lower number is better, because it means you’re getting paid more quickly, and seeing cash flow into your business. But this is a ratio that only really makes sense when you compare yourself with other companies in your industry. Payment terms can vary widely depending on the type of business you do and who your customers are. Retail businesses tend to have very low DSO ratios, because they get paid almost immediately at the point of sale. Companies whose main customers are large businesses, on the other hand, tend to have higher DSO ratios, because those customers expect to be given favorable credit terms.

How to Improve It

If you want to get paid faster, one obvious strategy is to renegotiate terms with your customers. If you usually give people 45 days to pay, for example, you could cut it to 30 days. But be careful not to be too stringent, and to end up alienating customers by demanding terms that are much stricter than those of your competitors.

Also take a look at your internal processes. One survey found that 25% of small to medium-sized businesses had at least $5,000 a month of revenue delayed due to invoicing errors. Investing in new invoicing software, or perhaps hiring new staff or training existing ones, could help you get paid more quickly. The advantage is that you don’t have to demand anything extra from your customers; in fact, they’ll be happy to receive prompt, error-free invoices.

4. Days Payable Outstanding

Why It’s Important

This is the other side of the coin. With Days Sales Outstanding, we looked at how quickly you get paid; Days Payable Outstanding (DPO) is about how quickly you pay your bills. It’s important to look at them both together, to get a clear picture of how cash flows in and out of your business, and whether the timing is to your advantage or disadvantage.

How to Calculate It

The formula is similar to DSO, but this time we’re looking at payables, not receivables, and at purchases, not sales. Accounts payable is another line from the balance sheet, and it measures money you’ve spent but not yet paid out. For example, if you ordered $15,000 worth of supplies on credit, that would show up in accounts payable. The formula is:

DPO = Accounts Payable / Average Daily Purchases

For “average daily purchases” we’ll use the “cost of revenue” line from the income statement, and divide by 365. Let’s see how that works, again using Canon’s 2013 accounts. The accounts payable figure is $6.4 billion, and cost of revenue is $18.4 billion, so the calculation is:

DPO = 6.4 / (18.4 / 365) = 6.4 / 0.050 = 128 days

How to Evaluate It

Canon is doing very well. It’s receiving payment from its customers in 60 days on average, but taking 128 days to pay its suppliers.

That means that if, for example, it makes a $10,000 sale and a $10,000 purchase on January 1, it will typically receive the $10,000 from its customer around the beginning of March, but not pay for its purchase until early May. It will have the money sitting in its bank account for a couple of months, earning interest andmore importantlycovering any unexpected expenses.

Most companies aim to manage their cash flow like this, some more successfully than others. So you want to evaluate your Days Payable Outstanding figure by comparing it to Days Sales Outstanding, and aim to have DPO being longer than DSO. 

Larger companies tend to have an advantage here, because they have more negotiating power. As a smaller company, you may struggle to match Canon’s impressive performance. But try to make sure you’re at least not putting yourself at too much of a disadvantage.

How to Improve It

The first thing you can do if you’re struggling for liquidity in your business is simple: just delay payments as much as possible. You don’t want to violate any agreements you’ve made, but just take full advantage of the payment terms you’ve been given. If you have 45 days to pay, then take the full 45 days. Even if you have the money available sooner, don’t pay it early. It’s important to have enough funds available to cover unexpected expenses as well.

You could also try to renegotiate terms, especially if your business has grown. If you’re ordering much larger amounts than you were when you started, see if you can negotiate more favorable terms with your supplier.

How to Keep Track

As with the profitability metrics, it’s best to look at these four liquidity metrics in combination. The quick ratio is the acid test of your ability to keep paying the bills, the interest coverage ratio measures whether your debt load is manageable, and the DSO and DPO help you see whether the timing of your payments with customers and suppliers is helping or hindering your attempts to stay solvent.

Compare your company with others in your industry, and also track changes in your own business over time. You can start right now, by going back to historical data and mapping the changes in each of the four metrics over the past few years. Then keep tracking them in the future, working to improve the results, and watching for changes. If the trends start heading in the wrong direction, you know it’s time to take action, using some of the tips in this tutorial.

This was the second part of our series on key metrics for your business to track. The four-part series continues next week with a look at some key measures of efficiency.

Resources

Graphic Credit:  Line Graph designed by Scott Lewis and  Calculator designed by Scott Lewis from the Noun Project.

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