Banker Tim liked business owner Jason. He felt strongly that with his drive and ambition Jason would be very successful. Unfortunately, in today’s highly regulated Dodd-Frank environment, feelings do not cover the auditor regulations.
Tim knew he was in the money rental business. Playing by the rules assured job security. Jason was drawn to be an entrepreneur because he did not like other people telling him what to do. He has a clear vision of where he is taking his company. Tim decided to have coffee with Jason and explain the rules of the game.
“Jason, how do you know if you are going to be paid, especially after doing the work?”
“I just expect people to be honorable and pay their bills.”
Tim, “Sadly that is not always true – especially when you borrow money. The good book states ‘the borrower is the servant to the lender.’ That means we set the rules to lend you money.
“Are you familiar with a balance sheet, Jason? It tells us what you owN and what you owE. One simple letter makes the difference.”
“N” is yours.
“E” others have claims against you.
“An important ratio is called “current ratio”. We calculate your total current assets divided by total current liabilities. This number should be greater than 1. The higher it is (1.0 – 2 etc.), the more cushion you have to pay your current obligations (what you owe). Do you know what your current ratio is today? How has it been trending the last 12-24, even 36 months? If that ratio number has been getting bigger, it is easier for me to loan you money.
“Another important ratio is “quick ratio.” Jason, when I say “quick” – what does that mean to you?”
“Fast – access.”
“Yep, that’s what we also want – a measure of your ability to pay off what you owe quickly. A number greater than 1 is very nice to maintain. Here’s the math:
“Cash + Cash Equivalents; like cash values of life insurance policies* + marketable securities** + net accounts receivable (what you’ve billed less what you owe vendors) divided by total current liabilities.
“Is this starting to make sense to you?
“There are many other ratios that tell us the operating efficiency of your company. A couple of examples are:
Accounts Receivable Turnover
Net Sales Revenue divided by Net Trade Accounts Receivable
Trends here are important. Are your credit policies reasonable or too strict? Do they strain your cash? Do you have lots of slow pay customers who are using your credit strength to carry them?
Inventory Turnover – total cost of goods sold divided by total inventory.”
Generally, the higher the inventory turnover, the better a company may be performing. Low turnover could mean obsolete or slow moving inventory items. Do you know what your turnover is?”
“One more for today, Jason.
Working Capital Turnover
Net Sales/ Total Current Assets minus Total Current Liabilities
Working Capital Turnover = Net Sales Revenue divided by Total Current Assets minus Total Current Liabilities.
“We look at your historical trends compared to industry norms.
“If a company’s current ratio, accounts receivable turnover, and inventory turnover remain constant while sales increase, net working capital must rise because more receivables and inventory are needed to support the increase in sales. If sales are decreasing, the reverse is true. A high ratio may result from favorable receivable and inventory turnover, which would indicate an efficient use of current assets; or it may be evidence of risk arising from potentially efficient use of current assets; or it may be evidence of risk arising from potentially insufficient short-term liquidity. This among a number of factors are used to determine what a willing buyer might be willing to pay for your company.
“Jason, are you aware that Ron Schutz- Planning Business Transitions, LLC does offer an informal valuation? They do not audit your information. It just gives you a starting point for discussions. Within the informal valuation is a 21 question exercise that helps them look at key strength and weaknesses of your company. You may want to contact them at firstname.lastname@example.org to learn more, or visit the website at www.ronschutz.com.
“Being transparent helps us to become more comfortable with you being trustworthy.
“These are just some of the rules we must play by to lend your money. Can you begin to appreciate why they are important?
“Do you get a regular summary of these and other key ratios on a regular basis (weekly-bi-weekly-monthly)?”
Jason realized he needed some help and had more work to do.
Securities and investment advisory services offered through World Equity Group, Inc., 1650 N. Arlington Heights Road, suite 100, Arlington Heights, IL 60004, 847-342-1700 Member FINRA, SIPC, a Registered Investment Adviser. SMART Group Houston is not owned or controlled by World Equity Group, Inc.
*Cash Value Life Insurance – Withdrawing from the cash value of a life insurance policy could reduce the death benefit and cause the policy to lapse.
**Marketable securities – The value of securities fluctuate with market conditions, so that when redeemed you may receive more or less than your original investment.