Quick, Current Ratios Can Help Diagnose Health of Your Firm

December is a good time to plan for next year--and you get a leg up on the job if you start by taking a look at two key financial ratios often ignored by business owners.

The ratios measure the ability of your company to generate its lifeblood--cash. And if you understand what these ratios say about your operations, you can make that lifeblood as healthy as possible.

Put another way, if you act on what these ratios tell you about your operations, you can make the most of them--a good strategy when you can’t get outside financing from a bank or private investors, and essential when you go looking for it.

The first ratio, the quick ratio, sometimes called the acid-test ratio, measures your ability to pay your bills over the short term. In essence, this ratio gauges your cash position right now.

The second, the current ratio, measures working capital more generally; indeed, accountants sometimes call this ratio the working capital ratio, because it tells you how many dollars you have to cover current debt--that is, debt due over the coming year.

Put together, strong quick and current ratios tell you that your business generates a healthy stream of cash. Weak ratios tell you to get to work.

How do you calculate these ratios?

To get the current ratio, you divide current assets by current liabilities, taking numbers from your balance sheet. Current assets include cash and other assets readily convertible into cash, plus inventories at cost or market value, whichever is lower. Current liabilities include accounts, notes and other liabilities payable in the near term--usually one year.

For example, if your balance sheet shows current assets of $1 million and current liabilities of $500,000, your current ratio is 2 to 1. Accountants sometimes express this ratio by saying that your current assets cover your current liabilities two times.

In general, the bigger the multiple the better, but your own ratio will reflect your tolerance for risk. (It should also reflect the averages for your industry, available in the Almanac of Business and Industrial Financial Ratios by Leo Troy, published annually by Prentice-Hall, or from your trade association.)

The quick ratio, in contrast, leaves inventories out of the picture--on the theory that no matter how you value it, you might not get everything you expect from selling your inventory, especially in a pinch. Put another way, inventory is an iffy thing, and out of caution, accountants ignore it when calculating the quick ratio.

To get this ratio, you divide current assets by current liabilities, omitting any value for inventory. Using the same example as above, if your balance sheet shows current assets of $600,000, excluding inventories, and current liabilities of $500,000, your quick ratio is 1.2 to 1.

Once again, the bigger the quotient, the better your position, but you judge your ratio good or bad depending on your tolerance for risk and on the averages for your industry.

From your banker’s standpoint, the quick ratio shows whether you can pay your bills over the short term--say, the next quarter. The current ratio shows whether you can liquidate a loan over the longer term--say, the next year. And as you may surmise, your banker likes to see a strong current ratio when you ask for a loan.

“The quick ratio tells you whether you have the cash flow to buy inventory to meet rising sales,” says Sanford Madnick, a CPA and partner in the Sherman Oaks accounting firm Clumeck, Stern, Phillips & Schenkelberg. “It is particularly useful when you have to wait some time after you make those sales before you collect--because it tells you whether you can.”

If you can’t, you have several options, according to Adrian Stern, another CPA and partner in the same firm. You may:

* Borrow to meet the shortfall.

* Discount your prices in exchange for quick payment.

* Or negotiate better terms from the supplier of your inventory.

“If you own a small business, you live and die with the way you finance your operations,” Stern says. “The current ratio is really important to your banker, but both the current and the quick ratios are important to you, too, because they give you a fair test of what’s going on with your business.”

A healthy business is not leveraged to the hilt, Stern adds, but rather shows a substantial excess of assets over liabilities.

“Running a business is like flying an airplane,” Stern says. “You go through air pockets that make the plane gain or lose altitude, and in business, you go through up and down cycles.

“You need a good cash position to ride out the drops in altitude--and to take advantage of your chance to go up.”

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Columnist Juan Hovey may be reached at (805) 492-7909 or via e-mail at jhovey@gte.net.