Equine Business - August 2009
August 12th, 2009
Mind Your Own Business:
Think - plan - organize - execute - make/save money
Before we move on, I would like to discuss one more liquidity ratio. Financial management is like math or a foreign language, if you don't use it you'll lose it. Since we took July off you might want to do a quick review of the May and June columns.
The last liquidity ratio I want to discuss is the Cash Ratio. If you remember I said in the May column, 'Cash in an equine business is KING'. Therefore, I call the Cash Ratio the Horsemen's Ratio.
The Cash Ratio formula is:
Cash Ratio (Horsemen's Ratio) = Cash + Cash Equivalents / Total Current Liabilities
The Cash Ratio is the most conservative liquidity ratio because it excludes all Current Assets except the most liquid: Cash and Cash equivalents (Marketable Securities). The Cash Ratio is an indication of a business's ability to pay off its current liabilities if for some reason immediate payment were demanded. Receivables and Inventory are eliminated from the Cash Ratio. If you remember, receivables are like ketchup and can be slow to collect and inventory is like molasses and very difficult to turn into cash (June column). A Cash Ratio of 1:1 is good. It means you can feed and care for your horses in difficult times. It also means you have the opportunity to gain an advantage and be a much better business with the potential to gain market share from your competitors.
In your Chart of Accounts you may have to manage or at least monitor what is called Other Assets. Other Assets include all Balance Sheet Asset Accounts not covered specifically in other areas of Asset Management. Often, such accounts may be quite insignificant to the overall financial condition of a business. Other Assets include accounts like: Deposits (utilities, telephone, etc.); Organization Costs (if you purchased your business); Accumulated Amortization of Organization Costs; Non-Current Receivables and Other Non-Current Assets. Unless you purchased your business, you probably only need to monitor your deposits so they are released as soon as possible. If they are sitting on your Balance Sheet, they are 'Cash at Rest'. Deposits do not earn interest (generally) and are not helping you grow your business.
In your Chart of Accounts your business's Long-Term Liabilities are accounted for by its debt obligations to other parties that last longer than one year. However, remember the current portion of the debt obligation (due within a year) is accounted for in your Current Liabilities (June column). Long-Term Liabilities include accounts like: Leases longer than one year (property, horses, etc.); Notes (loans from individuals, etc.); Land; Equipment (ranch equipment, tractors, ATV's, balers, etc.); Vehicles (ranch truck, horse trailer, etc.); Bank Loans and Other Long-Term Debt.
Management of Long-Term Liabilities is critical in evaluating a business's risk and its long-term solvency. There are three important ratios used to evaluate a business's risk and solvency. They all include a business's Long-Term Liabilities. Long-Term Liabilities need to be managed to keep a business growing or from becoming insolvent.
Debt Service Coverage: Is a measurement of a business's ability to generate enough cash flow to cover its debt obligations. This ratio needs to be greater than 1 (DSCR > 1). If it isn't greater than 1, the business needs to improve its profit or reduce its long-term debt. DSCR is income before income taxes + depreciation + amortization + interest / repayment of its debt obligations this year + interest.
DSCR = Net Operating Income / Total Debt Service
Total Debt to Assets: Is a measurement of a business's relative obligations. The Debt to Assets Ratio is not a particularly exciting one, but it is very useful. The ratio needs to be less than 1 (DAR < 1). If it isn't less than 1, the business needs to reduce its debt load or put tighter controls on its purchasing. Loan institutions will interpret a high ratio as a 'highly debt leveraged business'. Businesses with high ratios are placing themselves at risk, especially in high interest rate markets. Creditors are bound to get worried if a business is exposed to a large amount of debt and may demand that the business pay some of it back. DAR is Total Liabilities (current and long-term liabilities) / Total Assets.
Debt-Asset Ratio = Total Liabilities / Total Assets
Total Debt to Equity: Is a measurement of a business's leverage. This is a more stringent measurement of a business's financial risk than its 'Total Debt to Assets' ratio. The 'Debt to Equity' ratio is also called the 'Debt to Net Worth' ratio. It quantifies the relationship between the capital invested by a business's owner(s) and/or investor(s) and the funds provided by its creditors - the higher the ratio, the greater the risk to a current or future creditor. A ratio greater than one (DER>1) means assets are mainly financed with debt and less than one (DER<1) means equity provides the majority of the financing. A lower ratio means your business is more financially stable and is probably in a better position to borrow now and in the future. However, an extremely low ratio may indicate that you are too conservative and you are not letting your business realize its full potential. If the ratio is greater than 1, the business probably needs to improve its profit, get additional investment or sell off unproductive assets (May column). Creditors will interpret a high ratio as a 'highly debt leveraged business'. Businesses with high 'Debt to Equity' ratios have the same interest rate exposure and creditor scrutiny as a business with a high 'Debt to Asset' ratio. DER is Total Liabilities (current and long-term liabilities) / Shareholders Equity.
Debt-Equity Ratio = Total Liabilities / Shareholders Equity
Equity is the ownership interest in a business and can be in the form of common stock or preferred stock. It is also refers to total assets minus total liabilities, in which case it is referred to as shareholder's equity or net worth or book value. Equity in a horse business generally comes from the funds used to start the business, additional funds put into the business and retained earnings. Retained earnings are a business's net income (profits). If a business losses money the loss is subtracted from its equity.
The Equity Chart of Accounts should reflect the types of transactions that affect the Owner Equity and how the Equity is managed and measured. Possible accounts include: investments, withdrawals of cash by the owner, retained earnings, and income / expenses incurred. Income and Expenses incurred are temporary 'accumulation accounts' that are 'flushed' at the end of an accounting period and show up back in the business's Equity as retained earnings. The 'Debt to Equity' ratio is a good indicator of the level of leverage used by a company as explained above. The Equity ratio measures the proportion of the total assets that are financed by stockholders and not creditors. A low equity ratio will produce good results for stockholders as long as the company earns a rate of return on assets (ROA) that is greater than the interest rate paid to creditors. Remember, if an Asset isn't producing and returning an acceptable ROI, fix it or sell it (May column).
The Income Accounts in a Chart of Accounts are accounts into which revenue is collected and closed at the end of an accounting period. The resulting income minus the expense balance equals the net income or loss from the operations of the business. The income accounts should reflect the sources of income in your horse business. If you have multiple sources of income an account should be identified for each source so that source can be managed and measured. Possible accounts include: Boarding, Training, lessons, Breeding, Racing, Showing, etc. Spending time and money on an income source that is not profitable is not good business. If you have an income source that isn't profitable you have two choices; figure out why it isn't profitable and make it profitable, or eliminate it as a source of income and additional expense. Possible ways to improve your business's profitability are:
- Increase sales (expand your market reach and customer base)
- Differentiate your business from your competitors (exceptional customer service (free if done properly), offer more amenities with a minimal increase in expenses, ....
- Advertise more - watch the expense
- Increase your exposure in your market (club attendance, horse shows and events, .....)
- Raise prices (be careful - your still need to be competitive and product quality does have its limits)
- Reduce expenses (new suppliers, eliminate waste, establish purchasing procedures and limits, .....)
I can't emphasize enough that in business it all starts with a sale. Make sure the income accounts you identify enable you to measure and manage your income sources. In a future column we will discuss 'Breakeven Analysis' and how it applies to product pricing and sales strategies.
The greatest number of accounts identified in your Chart of Accounts will be the accounts associated with expenses incurred in the daily operation of your business. Expense Accounts should take into consideration non-capital expenses associated with generating sales and operating your business. Care should be taken to identify the accounts that reflect how you want to measure and manage your business expenses. Many Expense Accounts will need to be divided further into Subaccounts so you can have the detail you need to measure and manage your Suppliers, Reduce Cost, Improve Quality, Optimize Purchases, Minimize Inventory, Minimize the Use Cash and many more expense related decisions. The equineGenie Horse Management and Business Software System includes a complete list of horse business expense accounts and allows a business to define multiple subaccounts for each primary account.
In future columns we will use a Chart of Accounts to explore how to measure, manage and improve a horse business. I suggest you do a Cash Ratio (Horsemen's Ratio) 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.
We have concluded the overview on how to set up a Chart of Accounts. We are now ready to use what we have learned to measure and manage a horse business.
'If you can't measure it, you can't manage it.'
Bob Valentine, Ph.D.