So how can you measure in your business your ability to cover your day to day costs? This really comes from being able to understand your “liquidity”. What does being ‘liquid’ actually mean? Well, for me it means that if you had to get your hands on cash quickly to meet your obligations you could. It doesn’t necessarily mean it is easy (you can tell that by measuring how liquid you are), but it does mean you could probably juggle things to meet your obligations.
Balance Sheet
On the Balance Sheet assets and liabilities are split in to two categories;
- Current
- Non-current
Current means the asset or liability could be converted into cash within 12 months. Non-current means conversion would take longer than 12 months. So, in financial terms, 12 months is the threshold.
I use two key metrics to measure liquidity. They are both calculated using data related to current assets or current liabilities:
- Current Ratio
- Quick Ratio
The first is most relevant to businesses with no inventory, whilst the second makes allowance for the impact of inventory.
As you might expect, liquidity is focused on measuring that everything looks okay in the short term (the next 12 months). It uses the “current” elements from the balance sheet rather than the “non-current”.
Current Ratio
This measures the ratio of your current assets to your current liabilities:
If the ratio is > 1.0 then you are liquid (you have more current assets than you do current liabilities). If it is < 1.0 then you aren’t (you have more current liabilities than you do current assets). The larger the number, the better your liquidity. Essentially you are demonstrating that you can safely cover all your liabilities within the next year and have some left over.
Quick Ratio
The Quick Ratio is a slightly better measure if you are a business that holds inventory to operate (manufacturing related businesses or businesses that deliver some sort of physical product as part of their service offering). It measures your liquidity but excludes the inventory
The ratio value means the same as the current ratio, but it measures your ability to cover your liabilities within the next 12 months without having to get rid of your inventory. The presumption is that your inventory is required for you to generate revenue, so if you were to liquidate that outside So your normal manufacturing process, that it would impair the business results.
So, like the Current Ratio, a Quick Ratio > 1.0 demonstrates that the business is liquid, whilst a Quick Ratio < 1.0 says that the business is not liquid. As a rule of thumb a Current or Quick Ratio > 1.3 is seen as ideal as the extra amount provides a margin of safety.
Wrap Up
So how well placed is your business in covering its day to day costs? Once you know, you can turn your attention to discovering how well-oiled your business operations are.