Many small business owners think that their balance sheet is confusing and best left to accountants and bankers to understand. However even having a basic understanding of your balance sheet can give your company an edge in positioning your company for long term growth. In addition, a strong balance sheet can also:
- Help you weather any short-term downturn in the market.
- Make you look stronger financially when you are applying for larger leases or loans for real estate or larger equipment.
- Help you achieve top dollar when you are looking to sell your business.
One of the most important ratios to look at is your current ratio. Before diving into what the ratio is, an explanation of current assets and current liabilities is needed.
Current Assets – These are things that can be sold or liquidated quickly. The timeline on these assets are items that can be used/sold in less than 1 year. In this category, we include assets such as cash in the bank, accounts receivable, current inventory and prepaid expenses.
Current Liabilities – These are financial obligations due within the next year. In this category we include short term debt like accounts payable, company credit card debt, the portion of loans that need to be paid in the next year, and rent. Put simply, current liabilities are the sum of everything owed in the next year.
Having now defined these, the current ratio is simply the total sum of the assets divided by the total sum of the current liabilities. For example, if a company has $250,000 in current assets and current liabilities, then the current ratio would be 1 to 1. A decent current ratio is 1:1, however, a strong current ratio is 1.5 or better.
We have reviewed many financial statements where the business owner thinks the company is strong financially only to realize that their current ratio is below 1. This means they don’t have enough assets on hand to fund their obligations due within the next year. This would be a red flag for investors in a company as it shows the company may have to raise additional cash in the future to keep the company operating.
Now that we know what makes a strong current ratio, consider this scenario:
A customer is looking a funding a $100,000 piece of equipment. Their current ratio is 1:1. To further protect their current ratio should they do a 2 year or 5 year term on the equipment?
- A 2 year term at a basic 5% interest rate yields payments of $4,387 a month.
- A 5 year term at basic 5% interest rate yields payments of $1,887 a month.
From what we know about current liabilities,
- the 2 year term increases current liabilities to $52,644 (12 X $4,387)
- the 5 year term increases current liabilities to $22,644 (12 X$1,887)
The longer the term, the less the impact on the current ratio. In addition, assuming the equipment generates revenue, the increased revenue will have a more favorable impact on the current ratio with a 5 year term versus a 2 year term.
There is one last issue regarding your current ratio to consider and that’s when you are evaluating whether to obtain a lease or a loan for an equipment acquisition. Many loan documents have thresholds on the current ratio that need to be maintained. If you loan documents have terms requiring you to maintain a certain current ratio, then be careful as any drop in this ratio could put your business at risk of a forced payoff. When the recession in 2008 occurred, many business owners experienced forced payoffs and lost their assets and property to their bank. In future articles, we will explain other important ratios to consider and how they can impact the cash flow and growth of your business.