Before you finish reading this article, more than 10 businesses will close their doors for good in the U.S. You can read the details of this statistic here.
The reasons for this sorry state of affairs are many and varied, but one of the main reasons is poor cash management. For quite some time I have been hearing the lament “… I’m making a profit, but I can’t pay my bills.” Actually, cash crunches often occur at the same time that business is booming.
The underlying problem is that way too many business owners fail to focus on liquidity. They do not realize, or understand, that cash is the lifeblood of their business. It comes as a shock when they are clobbered with a cash squeeze while their business is profitable.
How does this happen? Well, the answer is really quite simple: most business owners are so busy “selling” and growing their business that they take their eye off the “vital signs” of their business’s health.
What are these vital signs? There are several, but the ones that are usually ignored are found on the Balance Sheet of your business’s financial statements. These vital signs are the ones that bankers and investors usually study in great detail—and are usually the ones that cause the most loan turndowns.
Here is a list of the bare minimum of vital signs that every small business owner should be closely monitoring—and then changing their business practices to improve them:
This is simply your Current Assets divided by Current Liabilities. This gives an indication of how likely you are to pay your bills on time. A ratio of 1:1 is absolute minimum (otherwise you will likely not be able to pay your bills). A ratio of 2:1 is generally considered as the desired minimum for a successful business.
This ratio is calculated by adding cash and receivables together, and dividing them by Current Liabilities. This is often called the “acid test,” because it concentrates on the liquid assets of your business. A desired quick ratio would be at least 1:1. It should be noted that your receivables need to be “clean”—that is, no questionable or uncollectible receivables should be included… otherwise, you are only fooling yourself.
This is simply Current Assets minus Current Liabilities. This is like a revolving fund of money that is needed to carry out your day-to-day business activities. A lack of working capital is usually the bane of most small businesses and is routinely blamed (often falsely) for the large number of business failures.
This is your Total Assets minus Total Liabilities. It gives an idea of what your business is worth, and is most valuable when following the trend—is it trending up or is it trending down?
There are several different leverage ratios, but, for small businesses, this ratio is usually calculated by dividing Total Liabilities by Net Worth. This ratio indicates how much your business relies on debt to operate. It is sometimes called “debt to equity” ratio. Obviously the lower the ratio, the better. Anything above 1 is a red flag that there may be too much debt for the business.
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These are only the bare minimum of vital signs from your Balance Sheet, and each industry has their own vital signs that should be added to these. Then, of course, there is the profitability issue that also needs to be followed on your P&L statement.
So, if your business is having trouble paying its bills—even though it is profitable—it would be a good idea to check out the “vital signs” of your business to determine just how “healthy” your business is… you might be surprised.
Next week I will be posting an article on things you can do to improve your cash flow—so watch for it.
Have any of you ever experienced a cash crunch while running a profitable business?