10 financial concepts you should master
Here is lesson nine in unwrapping essential financial concepts and how they will help you run your business.
The quick ratio
Liquidity ratios help a business owner judge their ability to cover the debts in their business. One of the most common is the “quick” ratio, which seeks to provide the answer to a simple question: If my sales dried up tomorrow, would I have the short-term assets on hand to cover my short-term debts?
The calculation involves adding up cash in the bank, shares or other instruments that could be quickly turned into cash (many SMEs will not have these assets on their balance sheet), and accounts receivable. This total is then divided by total current liabilities (including accounts payable and short-term financing facilities such as a bank overdraft) to calculate a ratio.
It is important to note that the quick ratio calculation does not include stock – this ratio is designed to give you a picture of your ability to meet short-term obligations without having to liquidate stock.
Say a business has $1 million of cash plus $2 million of accounts receivable, as well as $1.5 million worth of current liabilities. We would add $1 million (cash) to $2 million (accounts receivable) to get $3 million and then divided this by $1.5 million (accounts payable), giving us a ratio of 2:1.
That is, this business has twice the amount of cash and other “quick” assets on hand to cover its short-term liabilities.
A ratio of 2:1 is considered to be quite healthy. Indeed, anything over a ratio of 1:1 suggests the business is well placed to meet its short-term obligations.
However, entrepreneurs would be well-served to do a little bit more digging to ensure they are comfortable with their ability to cover short-term obligations. If your accounts receivable are much higher than your cash, and you have issues with collecting outstanding invoices, then you may still have some issues paying short-term debts.
With this in mind, you may need to use the quick ratio in conjunction with:
• Previous debt collection performance
• Historical financial performance
• Cashflow forecasts
• Analysis of economic conditions