Your financial accounts will reveal your history – but not your future. But since you can’t separate the past from the future, it is the best place to start. There is one magic, simple ratio that will tell you instantly how the decisions you have made in the past have positioned you for the future.
There are three different types of ratios that are typically considered (by banks and analysts):
Efficiency Ratios – measure the quality of the firm’s receivables and how efficiently it uses and controls its assets and so forth. (E.g. Stock turns)
Profitability Ratios obviously measure how well a company performs based on how profit was earned relative to sales, total assets and net worth. (E.g. Net Profit Margin.)
Solvency Ratios measure the financial soundness of a business and how well the company can satisfy its short- and long-term obligations.
One of the key solvency ratios analysts are fond of is the ‘quick ratio’ – also referred to as the ‘acid test ratio’.
This is an important ratio because it really is the ‘acid test’ for a business’s liquidity. It is similar to the current ratio (which compares current assets and current liabilities) – except that it basically strips out inventory because it is often difficult to liquidate.
The formula is: [Cash + Accounts Receivable] / Current Liabilities
I always look at this ratio as a quick sanity check because even if you don’t have an accurate or up-to-date balance sheet, most SME owners will have a reasonably good idea of cash and receivables – and also of their debt. (Even if your figures are estimates, it is still worthwhile running a quick check.)
A ratio of 1 (or more) is healthy – and this is what a bank will look for before they will add to the liabilities column.
Most people intuitively understand the underlying principle: your ‘liquid assets’ should be equal or greater than your ‘short term debt’.
Put differently: if the man comes knocking on the door, can you pay?