There are many ways to run a business and many ways to describe how businesses can be run. Some of the nomenclature is “By gut instinct,” “By the book,” “By objective,” “By committee,” “By the KPI’s,” “By micromanaging,” “By board directive,” and “By the seat of your pants,” just to name a few. Perhaps the best method is “By the numbers.”
Leaders of businesses that are run by the numbers generally make better decisions and are less likely to be seeking ways to stave off irate creditors, loss of credit lines or bank foreclosure.
What are the numbers business people should know?
The following is the first part in a series of blog posts dealing with how to calculate the important business numbers and recognize the importance of what is learned by the calculations. The information is from “Formulas for Success” from Vistage Worldwide* but can be attained through college business management textbooks and courses.
Vistage: “Formulas for Success”
“Want to know how your business is really doing? Your Key Financial Ratios will tell you whether your business is healthy and trending up or trending down. To understand your business, THE TREND IS YOUR FRIEND.
BALANCE SHEET RATIOS
The balance sheet gives you a snapshot of the overall health of the business as of the date on which it calculated. The balance sheet is for that date only. It describes the assets and liabilities and ownership position on that date. To really understand the health of the business you need to compare balance sheet data over several periods of time.
The four key balance sheet ratios are:
Measure whether you have enough current assets (defined as anything which normally turns into cash within a year) to meet your current liabilities.
Current ratio = Current Assets / Current Liabilities
Measures how much of the company is financed by borrowing versus owner equity. This ratio plays a major role in determining how much you can borrow and at what interest rate.
Debt-to-Equity Ratio = Total Liabilities / Net Worth
Measures the company’s ability to use its near cash or quick assets to immediately extinguish or retire its current liabilities. Quick assets include those current assets that presumably can be quickly converted to cash at close to their book values.
Quick Ratio = (Cash + Marketable Securities + AR) / Current Liabilities
Measures the capacity of the business to incur debt as a multiple of EBITDA (Earnings Before Interest, Taxes, Depreciation & Amortization). Banks generally look at less than two as a conservative ratio.
Leverage Ratio = Debt / EBITDA
Why Are These Key Balance Sheet Ratios Important?
Because the key balance sheet ratios measure the amount of risk in a business. The current and quick ratios (also known as liquidity ratios) measure the company’s ability to survive a short-term financial crisis. The debt-to-earnings ratio (also known as the safety ratio) measures the company’s ability to survive adversity.
If sales and revenues continue to climb while these three measures show a decline (a scenario that happens all the time in fast-growth companies), you have a real problem on your hands because you cannot finance the growth. You will grow your company out of business!”
Business By the Numbers Part 2 will feature Profit and Loss Ratios.
*About Vistage (from Vistage.com): Since 1957, Vistage has been bringing together successful CEOs, executives and business owners into private peer advisory groups guided by expert executive coaches, known as Vistage Chairs. This assembly of peers & expert leaders makes up Vistage Worldwide, an executive coaching organization.
From the beginning, our coaching Chairs have been at the heart of what makes the Vistage experience so powerful for so many members. Vistage Chairs are a distinguished group of business leaders who come to us from a wide range of industries. Some have owned businesses, many have been CEOs of domestic and international companies, and all are united by a desire to share their insight and expertise to educate other business leaders in their communities through executive business coaching.
About the Author
My name is Jim and people usually call me Jim. Sometimes I’m called James, usually at a doctor’s office. My favorite season is Summer because I like warm, sunny weather. I also like the colors of Autumn. My favorite hobby now is reading, but in the past I spent a great deal of time with my coin collection and drawing and painting pictures. My favorite sport is baseball and the Yankees are my team. I coached baseball and softball for nearly twenty years with my three children. My favorite activity is going out to dinner, throw in a little rock music from the 60’s and early 70’s and it’s a good night. My favorite quotes: “If you think you can do a thing or think you can't do a thing, you're right.” - Henry Ford. “I have not failed. I've just found 10,000 ways that won't work.” - Thomas A. Edison. “Opportunity is missed by most people because it is dressed in overalls and looks like work.” - Thomas A. Edison.More Content by Jim D'Amico