Mind Your Own Business:
Think - plan - organize - execute - make/save money
Before we continue setting up a measurable and manageable Chart of Accounts, I would like to discuss Current Assets in a little more depth. If you haven't read the column in the May newsletter, or need to refresh your memory, I suggest you might do a quick read as this column is a continuation of the May column.
Current Assets play a major role in two important financial measurements: the Current Ratio and the Quick Ratio. The Current Ratio is one of the best known measures of a business's financial strength. The Quick Ratio is sometimes called the "acid-test" ratio, because it is one of the best known measures of a business's liquidity (available cash). In both ratios Current Assets are in the Numerator. The Numerator is the part of a ratio (common fraction) appearing above the line and representing the parts of the whole that are being considered. The difference between Current and Quick ratios is the Current Assets that are included in the respective Numerators. Current assets are a category of assets on the Balance Sheet (future column) that represent cash and assets that are expected to be converted into all cash within the next 12 months. In the May column we identified Current Asset as Cash Accounts, Investment Accounts, Accounts Receivable and Inventory. I classify them in three categories by a measure of their liquidity; Cash is Water, Investments and Receivables are Ketchup, and Inventory is Molasses. Because the Current Ratio is a measure of a business's financial strength, all Current Assets are included in the Numerator of the Current Ration. However, since the Quick Ratio is a measure of a business's liquidity, only liquid Assets like Cash, Investments and Receivables are included in the Numerator of the Quick Ratio. The reason inventory is not included is it is difficult to turn inventory into cash in a short period of time, i.e., slow moving molasses. Sometimes even Receivables are questionable if you have too many slow paying customers. But, before we can do any analysis or reach any conclusions related to the Current Ratio and the Quick Ratio we need to discuss Current Liabilities and what they represent.
Current liabilities are what a business currently owes to its vendors and creditors. Current Liabilities are short-term debts, all due in less than a year. Paying them off normally requires the business to convert some of its Current Assets into cash. Beyond simply being bills to pay, liabilities (confusing as this might sound) are also a source of assets. Any money that a company pulls from a line of credit, or postpones paying from its accounts payable, is an asset that can be used to grow the business. For example, delaying your payables to your vendors from 30 days to 60 days can increase your Cash by the amount owed over the next 30 days. This is only viable if your use that cash to improve your business. As the expression goes; "don't rob Peter to pay Paul".
There are five main categories of Current Liabilities.
- Accounts payable: This is the money the business currently owes to its vendors, partners, and employees -- the basic costs of doing business that the business hasn't yet paid.
- Accrued expenses: Unpaid payroll expenses, unpaid interest on notes, and taxes incurred but not yet paid
- Income tax payable: This is a specific type of accrued expense -- the income tax a business accrues over the year, but does not have to pay yet, according to various federal, state and local tax schedules.
- Short-term notes payable: Notes a business has that need to be repaid within the next 12 months.
- Portion of long-term debt: The portion of a business's longer-term obligations that need to be repaid within the next 12 months.
Setting up a measurable and manageable Chart of Accounts in the Accounts Payable category can have a significant operating and financial impact on a business. Although Accounts Payable is a primary category under Current Liabilities, a business should use a system that allows it to define multiple vendor subaccounts for the same products and services. Defining a separate subaccount for each vendor lets a business measure that vendor's impact on the business's use of cash, the vendor's product and service quality and the vendor's delivery performance. A late load of hay is trumped by a late load of bad hay. The right system that is setup correctly will only allow this to happen once. However, the proper vendor selection will prevent it from ever happening (another future column). Remember, the items you select should help you optimize your work flow, have a positive influence on your profitability and, last but not least, conserve cash. Measuring your vendors and what they supply is a major component in this objective - price, terms, quality and delivery.
Another category under Current Liabilities that deserves attention is Short Term Notes Payable. This is particularly true if a business has multiple short term notes - and many do. The Chart of Accounts in this area should allow measurement and management of each note. The correct Chart of Accounts associated with a note will enable the business to minimize a note's impact on the business's profitability and cash. The business will be able to make the correct management decisions on each notes and the notes in total - which ones to pay off, which ones to renegotiate, which ones to discount and sell.
Now we have a better idea of what makes up a business's Current Liabilities, we can use our Current and Quick Ratios to make our first financial analysis of a business. In both ratios the Total Current Liabilities are in the Denominator. The Denominator is the number below the line in a ratio (simple fraction), which indicates the number of parts making up the whole.
The Current Ratio formula is:
Current Ratio = Total Current Assets / Total Current Liabilities
The main question the Current Ratio addresses is: Does your business have enough Current Assets to meet the payment schedule of its current debts with a margin of safety for possible losses in Current Assets, such as inventory shrinkage or uncollectable accounts? A generally acceptable current ratio is 2:1. But whether or not a specific ratio is satisfactory depends on the nature of the business and the characteristics of its Current Assets and Current Liabilities. The minimum acceptable current ratio is obviously 1:1, but that relationship is usually playing it too close for comfort.
If you feel your business's current ratio is too low, you may be able to improve it by:
- Paying off some debts. (Yes)
- Increasing your Current Assets from loans or other borrowings with a maturity of more than one year. (Hum - most likely delaying the problem)
- Converting non-current assets into Current Assets. (May column, Asset Management)
- Increasing your Current Assets from new equity contributions. (Yes - Grow the business)
- Putting profits back into the business. (Yes - It all starts with selling something)
The Quick Ratio is computed as shown:
Quick Ratio = Cash + Investments + Receivables / Total Current Liabilities
The Quick Ratio is a much more exacting measure than the Current Ratio. By excluding inventories, it concentrates on the really liquid assets, with value that is fairly certain. It helps answer the question: If all sales revenues should disappear, could my business meet its current obligations with the readily convertible "Quick" funds on hand? An acid-test of 1:1 is considered satisfactory unless the majority of your "Quick Assets" are in accounts receivable, and the pattern of accounts receivable collection lags behind the schedule for paying Current Liabilities.
I suggest you do a Current Ratio and Quick Ratio on your business even if you don't operate as a business. Remember, spending your money wisely may provide the opportunity to attend another horse show or event or do something special with your horse. Think - plan - organize - execute - make/save money.
Next month we will conclude setting up our Chart of Accounts. Then we will use the system we have defined to make more financial performance measurements and discuss what they tell us and how they can help us.
'If you can't measure it, you can't manage it.'
Bob Valentine, Ph.D.