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That sounds too much like math!” Joe wrinkled his nose.

      “Ratios are just one piece of the management operating plan, Joe,” Vivian explained. “Ratio analysis is one of the most powerful tools for guiding your business going forward. Besides, once you have the whole process set up, it takes very little time to maintain it.”

      Becky added, “Remember how you’re always telling me that you think our accounts receivable are out of control? Well, now we’ll be able to know for sure and to track it on a regular basis.”

      “Well,” Joe said slowly, “show me how the accounts receivable ratio works. Then we’ll see if it does us any good.”

      The Basic Ratios and What They Tell You

      Ratios can be grouped into different categories based on the type of information they provide:

      • Solvency or liquidity ratios (e.g., current ratio, total debt ratio)

      • Asset and debt management ratios (e.g., inventory turn-over, times interest earned, payables turnover, receivables turnover)

      • Profitability ratios (e.g., profit margin, return on assets, return on investment)

      Check out Table 1 at the end of the chapter for a summary of all the ratios we’ll discuss.

      Solvency or liquidity ratios

      Solvency ratios (sometimes called liquidity ratios) indicate how well your business can pay its bills in the short term without straining cash flows. As you can well imagine, your lenders are usually quite interested in the short-term solvency of your business. (They want to make sure they get their money back!) Some commonly calculated solvency ratios are:

      • Current ratio

      • Total debt ratio

      Current ratio

      The current ratio is one of the best measures of whether you have enough resources to pay your bills in the next twelve months. It is calculated as —

       Current ratio = Current assets ÷ Current liabilities

      The current ratio can be expressed in either dollar figures or times covered. For example, a business has total current assets of $4, 325 and current liabilities of $3, 912. The business’s current ratio would be —

       Current ratio = Current assets ÷ Current liabilities

       = $4,325 ÷ $3,912 = 1.11 : 1

      In other words, for every dollar in current liabilities, there is $1.11 in current assets. You could also say that the business has its current liabilities covered 1.11 times over. For a refresher on current assets and current liabilities, refer to Bookkeepers’ Boot Camp, the first book in the Numbers 101 for Small Business series.

      To a lender, the higher the ratio, the more secure is their investment in your business. The same is generally true for you as the business manager; you want the ratio to be at least one or greater. However, if your current ratio is higher than normal for your business, it may indicate that you are not using your resources effectively. This might happen because you have one (or all) of the following situations:

      • Abnormally high inventory levels (i.e., you are over-stocking the pantry)

      • Surplus cash sitting in the bank that should be invested long term (or used to pay down current liabilities)

      • An accounts receivable collection problem

      Total debt ratio

      The total debt ratio measures the long-term solvency of your business. It shows you how highly your business is leveraged, or in debt. The total debt ratio is calculated as:

       Total debt ratio = Total debt ÷ Total assets

      Just like the current ratio, you can express the total debt ratio in dollars or times. For example, if a business has a total debt of $12,673 and total assets of $9,412, its total debt ratio would be —

       Total debt ratio = Total debt ÷ Total assets

       = $12,673 ÷ $9,412 = 1.35 : 1

      In other words, for every dollar you have in assets, the business has $1.35 in liabilities. You could also say that the business is leveraged 135 percent or that its assets cover its liabilities 0.74 times over ($9,412 ÷ $12,673).

      In the case of the total debt ratio, you would want the result to be one or less. The lower the ratio, the less total debt the business has in comparison with its asset base.

      The total debt ratio would be of interest to your long-term lenders. For example, if your business owned the plant in which it operates and the bank has loaned the business money by way of mortgage against the property, the bank would be very interested in the long-term health of your business. Highly leveraged businesses risk becoming insolvent and declaring bankruptcy.

      Asset and debt management ratios

      Asset and debt management ratios tell you how well your business is managing its resources to generate sales. There are four main ratios in this category:

      • Inventory turnover

      • Receivables turnover

      • Payables turnover

      • Times interest earned

      Inventory turnover

      The inventory turnover ratio answers the question, “How long does my inventory sit before it gets sold?” This is an important question because there are warehousing and other costs associated with holding inventory. The ratio is calculated as follows:

       Inventory turnover = Cost of goods sold ÷ Ending inventory

      If a business’s cost of goods sold (cogs) during a period is $87,621 and its cost of goods remaining in inventory at the end of the period is $9,783, the inventory turnover ratio would be —

       Inventory turnover = $87,621 ÷ $9,783 = 9.0 times

      We could say that we can turn over our inventory nine times in a year. A more useful interpretation is to calculate days’ sales in inventory, which is —

       365 days/Inventory turnover = 365 ÷ 9.0 = 40.6 days

      This tells us that, on average, the inventory sits for almost 41 days before it is sold. Some businesses use the average inventory for the year (beginning inventory plus ending inventory divided by two) and some businesses use the ending inventory for this calculation. It all depends on what you want to track. Using average inventory gives you a historical perspective (i.e., what happened during the year), whereas using the ending inventory gives you a forward look at your current inventory levels.

      In general, you would want this ratio to be as low as possible without having chronic shortages of inventory on hand. In a perfect world, inventory would materialize at exactly the time it’s needed for a sale. The inventory turnover ratio tells you how long you generally hold the inventory before it’s sold.

      Receivables turnover

      While the inventory turnover ratio tells you how quickly you can sell your goods, the receivables turnover ratio tells you how quickly you generally get the money for the sale into your bank account. The receivables turnover ratio is calculated much like the inventory turnover ratio:

       Receivables turnover = Sales ÷ Accounts receivable

      If

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