A ratio of less than one means you could run short of cash within the next year unless you generate additional cash. But the metric has some limitations, Schaefer noted. “For example, by including inventory in the calculation, it may provide a distorted understanding of the company’s very short-term cash flow,” he said.
The second liquidity ratio is the quick ratio, which is typically expressed as cash plus accounts receivable divided by current liabilities. Again, the quick ratio may not be perfect for gauging liquidity, but it is a useful and popular metric to pair with the current ratio.
3. Accounts payable days and accounts receivable days
Accounts payable days and accounts receivable days are also key, Schaefer said. “The owner can discover that they may be paying their suppliers too quickly, which is money they could be investing instead of distributing immediately, or they could find they are not receiving payments quickly enough from their customers,” he said.
Accounts payable days is expressed as accounts payable divided by cost of goods sold, multiplied by 365 days. What is a good accounts payable turnover ratio? It varies by industry, but generally, higher numbers are better.
Similarly, accounts receivable days is expressed as accounts receivable divided by sales multiplied by 365 days. Lower numbers are generally better. But this, too, will vary dramatically by industry.
For example, some industries routinely give customers a 30-day grace period for payments, especially those that bill for services, and other industries don’t get paid until the entire job is complete. So construction companies, for example, have an average accounts receivable days ratio of more than 60, compared with retailers’ average AR days ratio of about 20, according to data from Sageworks.
Because of this variation, Schaefer said, it’s tough to make sense of financial ratios unless you find quality industry data against which to benchmark your company. What is a good net profit margin? What are sound liquidity ratios?
“Without comparing your own business to others, how will you know if an account receivable days of 15 is great, average, or high?” he said.
Knowing how your metrics compare to other companies also helps you identify business areas that need fresh attention, Schaefer said.
Trade groups, surveys and information providers are among the resources for finding benchmarking data. The important thing is to find businesses of a similar industry, revenue size and geographical location.
“Business conditions can vary greatly between different areas of the nation, even if the companies are the same size and they make the same products,” Schaefer said.
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Mary Ellen Biery is a research specialist at Sageworks, a software company that develops software for financial professionals and small businesses. Biery is a veteran financial reporter whose works have appeared in The Wall Street Journal, Dow Jones Newswires, CNN.com, MarketWatch.com, CNBC.com, and other sites.
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