Thursday, October 28, 2010

Ratio Analysis: Part 1

Financial analysts often recommend ratio analysis as a way to measure the condition of a business. Many small business owners don’t know how to calculate the ratios or don’t understand what the ratios are telling them. We will discuss how to calculate important ratios and what they mean.

Financial ratios can be classified into four groups: liquidity ratios, activity ratios, leverage ratios, and profitability ratios. This week we will discuss liquidity ratios and leverage ratios.

Liquidity ratios help measure a business' ability to generate sufficient cash flow to pay it's current bills.
Liquidity is necessary to all business especially during economic downturns or slow periods for a company.

Current Ratio: This ratio is subject to seasonal fluctuations and is used to measure the ability of the business to meet its current liabilities out of current assets. A high ratio is needed if the business has difficulty borrowing on short notice.

      Current Ratio = Current Assets/Current Liabilities

Quick (Acid-Test) Ratio: The quick ratio, also known as the acid-test ratio is an even stricter measure of liquidity and is what saved many businesses when the economy fell apart in 2009.

    Quick Ratio = (Cash + Short Term Investments + Accounts Receivable)/Current Liabilities
Leverage (Solvency) Ratios. Solvency is the ability of the business to pay its long-term debts as they become due. An analysis of solvency looks at the long-term financial and operating structure of a business. The amount of long-term debt the business has is also considered. Solvency is affected by profitability, since in the long run no business will be able to meet its debts unless it is profitable.

Debt Ratio: The debt ratio compares total liabilities to total assets. It shows the percentage of total funds obtained from creditors. The more funding a business has from creditors, the more risk from a decrease in revenue and/or a decrease in profitability.

       Debt Ratio = Total Liabilities/Total Assets

Times Interest Earned (Interest Coverage) Ratio: The times interest earned ratio reflects the number of times before-tax earnings cover interest expense. It is a safety margin indicator in the sense that it shows how much of a decline in earnings a business can safely survive.

     Interest Coverage = Earnings before Interest and Taxes/Interest Expense

The key to all ratio analysis is what you compare the ratios to.  Industry standards are important as well as the business' own history.

Next week, we will discuss activity and profitability ratios.  What is your favorite ratio?

Tuesday, October 19, 2010

The Dangers Small Businesses Face When Hiring Employees

Employees are essential to the success of most small businesses and yet they are also one of the greatest sources of difficulties for small business owners. I wish the was some law requiring business owners to get proper training before they hire employees because there are so many things to know and so many problems can arise if you don’t handle employment issues correctly.

The IRS has a whole area dedicated to small business and the State of Wisconsin has its own site We recommend all business owners read the information on these sites BEFORE they even begin the hiring process. There are rules about what you can ask potential hires, there are guidelines to help you determine if the worker you are thinking of using is a subcontractor or an employee. The majority of situations will result in an employee, not a contractor and business owners will save themselves a great deal of trouble if they make this determination ahead of time. Even part time, occasional or temporary help usually fits the description of employee. Your accountant, attorney, marketing advisor are all contractors for your small business. The people answering your phone, sorting your mail, staffing your events are almost always going to be categorized as employees by the IRS.

There are rules about what employment related signs you must post at your business, paperwork your employees must file out and you must retain and file with the appropriate agencies (federal and state). There are schedules to meet as far as filing and paying payroll taxes which if you fail to follow will create large penalties and interest for your business and possibly for the owner personally.

There are many choices for processing payroll: online vendors such as Paychex, local payroll processors, and local accounting firms. Business owners should do their research and determine if it makes more sense for them to outsource this task or learn to do it themselves. Whatever the decision, education and training are essential to insure that all the rules are followed and all the schedules met.

Don’t lose money because you did not do your homework ahead of your hiring!

Tuesday, October 5, 2010

Other Sources of Financing for Small Businesses

While the economy is slowly turning around, many small businesses are frustrated by their inability to get bank financing. I recently read an article in the CPA Daily newsletter discussing alternatives to traditional bank financing.


Factors purchase outstanding invoices, allowing a business immediate access to cash instead of making it wait 30, 60 or 90 days for a customer to pay. Factors buy receivables generally without recourse, meaning they assume the credit risk of the business’ customer.

Equipment Sale and Leaseback:

If a business owns expensive equipment or machinery outright, anything from a fork lift to a printing press, it can find a lender who will buy the equipment for a lump sum and lease it back. During the term of a lease, the lessor (the lender) owns the equipment. When it ends, the lessee (the small business) can buy the equipment from the lessor or give it back and get a newer model.


As the name suggests, microloans tend to be smaller in amount, but can run as much as $150,000. "In many cases, that's enough to help them with working capital for a month or so and that's often all they need,” says Gary Lindner, chief operating officer of ACCION Texas, one of about 300 U.S. non-profit micro-enterprise lending institutions.

Merchant Cash Advance:

A handful of independent finance companies will give merchants a lump sum upfront in exchange for a share of their future credit-card sales. Different than a loan or lease arrangement, a merchant cash advance is based on a business’ monthly credit-card sales history. The upside: unlike a loan, there are no due dates and no fixed payments and it's faster to get approved. The downside: while there's no traditional interest rate, providers such as AdvanceMe, Merchant Warehouse, or AmeriMerchant will take a cut – called a split -- that is generally 15 to 17 percent of credit-card receivables.

Purchase Order Financing:

A financing agent advances money against a signed purchase order for finished goods or value-added products to help fund manufacturing and fulfillment of the order. This type of arrangement is helpful for companies such as import-export firms, which must pay for raw materials immediately but wait to get paid for their finished goods. Once goods are shipped and customers are invoiced, the transaction is closed out.

The upside of purchase order financing: it depends more on the credit standing of a business’ customer rather than its own. The downside: providers of these advances take a cut of a company’s profits, usually in the range of 4 percent or less.

If you chose to go an alternative route, make sure you do your homework and pick a reputable provider of funds. Do any of you have other suggestions for small business financing?