Ratio analysis for your small business
How is your small business doing compared to last year, or compared to other businesses in your sector? Is it growing healthier, or headed for trouble? Many small business owners have only a dim sense of whether their business is thriving.
Revenue figures only tell part of the story. Your income number could be going up while behind the scenes, the business is on the verge of collapse due to cash-flow problems.
To get a better sense of your business's financial health, you need to look at the relationships between key figures in your business's income statement. This process is known to financial types as ratio analysis.
How does it work? Let's start by discovering how fast customers pay you, on average.
Figuring accounts receivable turnover
To figure this ratio, multiply your average daily outstanding receivables by 365 to get an annual receivables figure. Then divide that by your total annual sales on credit.
Example: Say your daily average is $15,000 -- times 365 is $5,475,000. If your business sold $100,000 on credit last year, it is taking nearly 55 days to collect a typical bill. If your terms are net 30 days, slow payers are robbing your business of vital cash flow.
Figuring accounts payable turnover
Let's compare this figure with the next ratio, accounts payable turnover, which tells you how quickly you have to pay your vendors. You want this figure to be larger than the accounts receivable days. That way, you can pay vendors with customers' money rather than having to shell out cash from the business and the wait until the customer payment arrives.
To find this ratio, multiply average daily payables by 365, then divide by the total purchases your business makes on credit each year.
If your average payables are $7,000 and you buy $75,000 on credit annually, you are paying vendors in an average of 34 days. But wait! Your customers are taking 55 days to pay. If you are a service business, this leaves an 11-day gap you might have to cover, a problem that often leads to business borrowing and a cycle of debt service that can hobble the company's growth.
Figuring inventory turns
Retailers need one more ratio to see the whole picture: You must add in your inventory turns, or how long it takes goods to sell. To get this one, multiply your average daily inventory by 365, then divide by the annual total cost of goods sold.
If you have $40,000 daily average inventory and your total yearly cost of goods is $110,000, it's taking nearly 24 days to sell a typical item.
Now we see your business's complete cash cycle: On day one you buy an item, and on day 24 a customer buys it on credit. Ten days later, on day 34, you pay for the item. Way out on day 79 -- 55 days after the purchase -- the client finally pays for the item.
Improving your cash cycle
Once you know your ratios, you should figure them again quarterly or even monthly. This reveals the trend in your business -- is your cash cycle getting better or worse?
Ideally, you want to improve your ratios so that customers pay you before you have to pay vendors. This way the business does not have to use cash reserves or incur debt to pay vendors while waiting for customer payments.
All the big retailers pay their vendors after customers pay them, a situation known as a virtuous cash cycle. You might obtain research on cash-flow norms in your industry from an association or research firm to get a more precise sense of how your business's cash-management practices compare with industry norms.
What can you do to improve your cash cycle? There are three points at which you can change your ratios:
Tighten up your credit. Identify your slowest payers and require them to pay cash. Institute firm credit policies and research customers' credit histories before offering them credit.
Ask for better vendor terms. If you're paying suppliers on net 15 days, ask if they might accept net 30 or 45 days instead. This buys you valuable time in which to sell and collect customer payments.
Improve your merchandise mix. Identify slow-turning items and eliminate them from your shelves, while ordering more of your quickest sellers. This will result in faster average turns, helping speed up the payment cycle.
A great advantage of knowing your ratios is that you can quickly spot developing problems. If over a few months' time you see average turns getting longer, or customer payment days lengthening, you know to take action to reduce those cycles.
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