Back before Saturday Night Live there was a radio comedy troupe called The Firesign Theatre. Their routines included a game show titled “Beat the Reaper” in which contestants were injected with a deadly disease and had less than a minute to analyze their symptoms and guess what disease they had. Those who did would Beat the Reaper. Those who didn’t … well, you get the idea. I suppose the comedy was all in the presentation.
A common tension-building device used by fiction writers is to place the protagonist in a situation where catastrophe is imminent and time is running out: Our hero is short on air, ammunition, fuel, time, or some combination thereof. If I was in such a situation, I might find some comfort in knowing just how long I had left. When the end came, I would at least know what had happened.
I wish I could say that about my first business. When the end came, I offered a dazed look to the accountant and exclaimed “What happened?”
She gave me a look reserved for the young and ignorant and said simply: “Let me see your books.”
I handed her my check registers along with a list of assets and liabilities and a box of receipts, which represented the extent of my bookkeeping back in those days. She grimaced and said, “Get back to me in two weeks.”
Two weeks later she handed me an approximation of my quarterly financial statements. In reviewing them it became clear what had happened to my business. It also become clear that I could have seen the end coming months in advance and saved myself a lot of trouble and embarrassment if I had just known how.
At the time, I blamed my financial problems on my inability to collect in a timely fashion from my clients (I operated a service business). I was profitable but short on cash. “If people would pay me what they owed me I could pay all my creditors right now” was my refrain. I made the mistake of counting on money I didn’t actually have in the bank.
I’ve smartened up since then, and have come to rely on two financial analysis tools to tell me if I’m in trouble or not and how long I have left to live (figuratively speaking). These tools are called the Acid Test Ratio and the Basic Defense Interval. The Acid Test Ratio (also known as the “Quick” Ratio) tells you whether you can get your hands on enough cash to pay the expenses that will come due in the next 30 days. It will also tell you what your comfort level can be. Until recently, a Quick Ratio of 2:1 ($2 cash for every $1 liability) was considered by banks to be the standard measurement of whether one had enough cash to keep up with expenses. Bank standards have relaxed in recent years. Personally, I like to know that I have a little cushion; I don’t like to cut it too close. (Note: Some accountants prefer to state financial ratios in annual terms, but I prefer monthly. I’ll change to annual calculations when my creditors start billing me annually.)
The Acid Test (Quick) Ratio is calculated as follows: (Cash + Marketable Securities + Receivables, including net profits from sales that you are reasonably certain of) divided by Current Liabilities equals the Quick Ratio. If you have $5,000 cash in your checking account, a $2,500 CD that you can cash in and expected net sales income of $9,400, then your total available cash will be roughly $16,900. If you have $12,238 in expenses coming due in the next 30 days, your Quick Ratio is $16,900 divided by $12,238 or 1.38: 1. For every dollar of current liabilities that will come due, you have $1.38 with which to pay them. You can pay your bills with a little to spare. The higher the ratio is, the more financially sound your business is in the short term. Tracking your Acid Test Ratio over time will enable you to see if your business is becoming stronger or weaker. Consistently low or diminishing Acid Test Ratios may be an indication of weak sales, high expenses or too much borrowing.
Of course, attempting to judge the health of one’s business by one ratio alone is like trying to gauge your body’s health by only taking your temperature. Like a thermometer, a financial ratio simply gives you a reading. Finding the solution to a problem will require further analysis.
What happens if you are in a severe sales slump and you’re not sure that you will make any (or few) sales? That’s where the Basic Defense Interval comes in: It tells you how long “you” have to live.
Here’s how to calculate your Basic Defense Interval: (Cash + Marketable Securities + Receivables + Sales Net Profits, if any) divided by [(Operating Expenses + Interest + Income Taxes) divided by 365] equals your Basic Defense Interval. In other words, take all the cash you can get your hands on quickly (quick cash) and divide it by your daily cash expenses.
For example: You have $16,860 in your checking account, $20,000 in convertible CDs and $60,000 worth of Microsoft stock. You’re making no sales at all. How long can you last? $16,860 + $20,000 + $60,000 = $96,860. Your ongoing daily expenses come to $1,247. How long can you last without sales? $96,860 divided by $1,247 equals about 78 days. In this situation, it’s best to cut back on all discretionary expenses; otherwise you’ve got to sell something or talk to a lawyer.
If you are making sales, then re-do this ratio calculation as often as you feel it’s necessary. When you’re sailing your ship in shallow waters you have to take depth soundings often or you’ll run aground. The same is true for your business.
Being able to use the above ratio analysis tools presupposes that your books are in good order. The reason my first business ran into trouble was that I couldn’t see the trouble coming. With solid bookkeeping practices and regular analysis, you’ll certainly be able to Beat the Reaper.
Previously published in Antique Trader Magazine
Originally posted 2015-03-26 15:16:00.