A handful of ratios can provide quick visibility into any business; financial ratios are early warning indicators.
Corporate accounting and finance is controlled by a large number of laws and consensus documents. You'll hear about things like the Financial Accounting Standards Board and generally accepted accounting practices. Some of the accounting rules make no logical sense. They are the result of tax laws made to encourage or discourage certain practices. Ever wonder why your company has some irritating rules for expense statements? Look to the rules that your company has to follow for accounting purposes.
As engineers, we sometimes think that management folks are the bad guys, or at least bumbling incompetents. However, as engineers progress through the management ranks, their focus changes from products and technologies to a series of questions like "Where does the business stand?" and "Can we actually afford to carry out our plans?"
The ugly business truth is that, even after you've delivered products and services to customers, you might not be paid on time -- or even at all. Seemingly irrelevant things (including delays) add up silently but quickly. Then one day you wake up to discover you're out of cash. When you're short of cash, the likelihood of making bad business decisions explodes. You cut the fat, eliminate the dead wood, right size, and make any number of minor and major decisions that will have a lasting impact on the business.
Business managers are paid to make these decisions, but they live in a decidedly non-engineering environment. How can they prevent unpleasant surprises? They have to rely on financial ratios (or accounting ratios), not just because the business may be so complex that it's the only way to sort through alternatives, but also because ratios are the fodder for investment decisions.
Key financial ratios
A handful of ratios can provide quick visibility into any business. Financial ratios are early warning indicators, especially when presented as time-series data. The trends often speak louder than the point-wise ratio of today. Financial ratios come in all shapes and sizes and can be made quite complex. Your company's finance department almost certainly employs a number of the more complex ratios, but you can quickly get an indication of what's really going on in your business based on some simple ratios.
Some business managers adhere slavishly to financial ratios, but ratios are not magic. That's why executives get the big bucks; they choose from among alternatives that may all be unpalatable. A few common ratios, taken with caution, can provide quite a bit of information about a company's relative performance. Financial ratios are tools. Each type of ratio is used for a specific purpose.
Three fundamental types of ratios encompass most of how businesses are measured: liquidity, activity, and profitability ratios.
Liquidity ratios measure the ability to adequately meet short-term obligations. (Did you notice the weasel word "adequately"?) If you personally had to pay all your bills today, could you do it with what is in your bank account (balance sheet for a business)? The quick ratio gives a snapshot of liquidity.
Current assets generally include cash on hand, cash in checking accounts, liquid securities, inventories, notes receivable due within one year, and accounts receivable. Current liabilities include current notes payable, accounts payable, payroll taxes, income taxes, interest payable, and other accrued expenses.
Let's consider Paul, a consulting FPGA design engineer who is in a cash squeeze. He can't pay his bills on time. The quick ratio helps reveal the cause. (The answer is obvious in this case but may not reveal itself as readily in a more complex case). His current assets include $17,000 in cash, $13,000 in accounts receivable, and $20,000 in FPGAs (stock inventories). We'll ignore inventories for now. Current liabilities include $28,000 in accounts payable and $4,000 in provision for taxes.
The quick ratio of 0.94 shows what's causing Paul's cash problem. His current liabilities exceed his liquid current assets. The goal is to keep the quick ratio higher than 1.1 to ensure that there are more current assets than current liabilities at all times. Paul needs more cash now.
The problem may be that he's not collecting fast enough from his customers. Maybe his inventory level is too high. Without a doubt, he needs more working capital now. The key will be whether Paul's liquidity problem is a temporary challenge or a long-term one.
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