Let’s take a look at your own company’s last balance sheet and check it out. Look for two things.
First, is that equity figure a positive number? (We hope it is!) If it is a negative number, it is a sign that your company is in trouble or maybe just that it is new and struggling. Whatever the reason, right now you don’t have enough assets to cover your liabilities. You’ll need a plan to change that situation as soon as possible.
Next, get out your calculator. Add the cash and accounts receivable figures on the assets side and write down the sum. Separately, add accounts payable and any other current obligations listed on the liabilities side and write down this sum. Then divide the first number by the second. What did you get? As a rule, the ratio should be greater than 1.00. If it isn’t it means you don’t have enough cash and near cash to cover your short-term obligations (those due in the next twelve months). Accountants call this the quick ratio or acid test. It is a useful tool for estimating at a glance whether your company is facing immediate liquidity problems. (“Liquidity problems” is accountant-ese for not enough cash.) However, it is only a first approximation. For one thing, you can have enough cash today and still run out of cash next month. For another, receivables are not always as good as cash: it depends on how old they are and how confident you are of your ability to collect, and people’s ability and willingness to pay you.
Please don’t get the quick ratio confused with another tool, the current ratio. Your loan officer at the bank probably likes to look at the current ratio because it adds items such as inventory and other current assets into the cash and receivables figure and compares that total with short-term obligations. Loan officers figure that, in a pinch, they can always convert inventory into cash and get their money back. But to a manager, the current ratio can be misleading. If a company carries a lot of inventory, for instance, the current ratio looks better than if it carries only a little, all else being equal. However, carrying a lot of inventory isn’t necessarily in a company’s best interest.
In sum, the balance sheet tells you some important information, like what the company owns and what it owes. But it also leaves out a lot. It doesn’t tell you whether the company made money last year. It doesn’t tell you where the company’s cash came from and whether it has a healthy cash flow. That’s why people invented other financial statements.
This is the 5th blog of 5 blog series that will be posted this week to help you understand one aspect of running a business that is crucial to be able to make informed business decisions for your business. We hope this helps you in your business venture and we look forward to providing you with more content soon.
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