by MHolland | May 1, 2024 | Accounts Payables, Accounts Receivables, Business Tips, Cash Flow
Over the last two weeks I wrote about how the three main financial statements of your business contain five sections as follows:
- Assets (the things you own)
- Liabilities (what you owe)
- Equity (what’s leftover for you)
(the above 3 sections are on the Balance Sheet)
- Revenues (the inflows into your business)
- Expenses (the outflows from your business)
(the above 2 sections are on your Income Statement)
To understand the story of your business month by month, year by year you need a sharper focus.
That sharper focus can begin with ratios.
Two weeks ago I wrote about liquidity ratios and profitability ratios.
Last week I wrote about Activity Ratios, namely Average Days Inventory, Average Days Receivable, Average Days Payable, and Cash Conversion Cycle.
This week I will write about…
Leverage Ratios
Leverage ratios measure the overall debt level of a business.
It is an indication of the business’s ability to repay new and existing loans.
A very low ratio can indicate a very cautious business that may be missing out on growth opportunities.
On the other hand, in a tough economy, too much debt can cripple your ability to repay your debt.
When interest rates are very low debt can be seductive, almost like an offer of free money.
However, when they go up, unless you have a highly profitable business and excellent cash-flow the interest expense alone can cause severe financial distress.
The way to manage your debt is to create a Forecast that looks at what could happen if rates climb and create scenarios for that possibility.
The other thing to do is to lock your loans into the longest term possible with a fixed rate of interest.
Here are two examples of leverage ratios…
Debt to Equity Ratio
This is a very simple ratio, calculated as follows:
Total liabilities divided by total shareholder’s equity.
A high ratio will indicate a business that is highly debt dependent and may have challenges getting additional loans if the economy is in a recession.
Bankers will look at a low ratio as being favorable to issue new loans. They will see that the shareholders have financed most of the assets.
Another leverage ratio is…
Debt to Asset Ratio
This ratio will indicate the proportion of assets financed by debt.
A ratio of greater than one will be an indicator that most of the assets are financed by debt.
The above two ratios indicate how much your business is at risk of economic downturns and increasing interest rates.
The next ratio will tell you how much profit you have to service your debt…
Debt Service Coverage Ratio
A high debt service coverage ratio tells you how much you have to cover your interest and principal debt payments.
First, you need to determine your EBITDA. This stands for Earnings Before Interest, Taxes, Depreciation and Amortization.
You take your EBITDA and divide it by your total interest and principal payments.
A high ratio here is preferable.
It will indicate that you have a lot of coverage to pay your financial obligations.
In Summary
Bankers will look at your leverage ratios closely to determine if you qualify for new loans.
Overall, the four sets of ratios we covered in these past three weeks tell you a story about your business that just looking at the main five sections will not.
Your profitability ratios will tell you how profitable your business is, and whether you are charging enough for your products and services. It will tell you how efficient you are in managing your business resources to generate a profit.
Your liquidity ratios will inform you of your ability to pay your obligations as they become due.
Your activity ratios will tell you two things:
- How well you are managing your working capital – cash, accounts receivable and inventory.
- How quickly you convert your working capital assets into cash.
Your leverage ratios will tell you and your banker how leveraged you are, and whether you have more than enough to cover your interest and principal payments.
Thanks for reading…
by MHolland | Apr 24, 2024 | Accounts Payables, Accounts Receivables, Cash Flow, Cloud-based Accounting
Last week I wrote about how the three main financial statements of your business contain five sections as follows:
- Assets (the things you own)
- Liabilities (what you owe)
- Equity (what’s leftover for you)
(the above 3 sections are on the Balance Sheet)
- Revenues (the inflows into your business)
- Expenses (the outflows from your business)
(the above 2 sections are on your Income Statement)
To understand the story of your business month by month, year by year you need a sharper focus.
That sharper focus can begin with ratios.
Last week I wrote about liquidity ratios and profitability ratios.
To recap, liquidity ratios – the main one being your current ratio – tells you how well you are able to pay your bills as they come due.
The profitability ratios include your Gross Profit Margin, your Net Profit Margin and Return on Equity. These tell you how profitable your business is and what your return on investment is.
This week I will write about…
Activity Ratios
There are three main activity ratios:
- Average days inventory
- Average days receivable
- Average days payable
The above three ratios can be summarized in what is called your Cash Conversion Cycle.
The intent of the above ratios is to show you how quickly you sell your inventory, convert your accounts receivable to cash and the time you take to pay your bills in order to conserve cash.
First, let us look at…
Average Days Inventory
To calculate this ratio, you first take your opening inventory for the period (month or year) and add this to your closing inventory. Then divide by two.
Take this average and multiply by the days in the period (for example 30 or 31 for a month) and divide this by your Cost of Goods Sold for the same period.
The smaller the number the better. A smaller number means you are selling your inventory more quickly. A longer number of days means your cash is tied up in inventory.
The next ratio is….
Average Days Receivable
This measures the average number of days customers take to pay for your goods or services.
For example, if you give your customers terms of 30 days, and your days receivable are running at, say, 25 days, then you are doing great.
You calculate your days receivable as follows:
Opening Accounts Receivable at beginning of the period (month for instance) plus Closing Accounts Receivable at end of the period divided by two.
Now, take the average accounts receivable times the number of days in the period (30 or 31 for a month) and divide that number by your Revenue for that same period.
Even if you have a small number, which is great, it is important to review each aged account receivable.
This is because fast payers can bring the average down, hiding slow payers.
In a tough economy, you are only as successful as your clients are successful.
The other thing to keep in mind is that your accounts receivable is what your customers will want to stretch out as long as possible. Your account receivable is their accounts payable!
The best way to get your receivables paid fast is persistent, constant communication. The cliché “the squeaky wheel gets the grease” applies here.
A large bad debt could cripple your business.
Now, let us examine…
Average Days Payable
This is a measurement of how long you take to pay your supplier bills, on average.
For this Key Ratio, longer is better.
Why? Because it means you are holding onto your cash longer.
However, you will not want to jeopardize your relationships with your suppliers.
You calculate average days payable as follows:
Opening accounts payable plus closing accounts payable (for the period) divided by two.
Take the average as above times the number of days in the period and divide that by the Total Cost of Goods Sold for the period.
Now, we can summarize all three of the above ratios into one number…
Cash Conversion Cycle
Your cash conversion cycle is the number of days, on average, it takes to convert your working capital into cash.
Here is how you calculate this ratio:
You simply add your Average Days Inventory to your Average Days Receivable and then subtract your Average Days Payable.
Let us assume you take 60 days on average to sell your inventory, and 20 days on average to collect your receivables, and 40 days on average to pay your supplier bills.
Your Cash Conversion Cycle is 60 + 20 – 35 = 45 days.
Is it possible to have a negative Cash Conversion Cycle?
Yes!
Let us say you turn your inventory every 20 days and collect your accounts receivable in 15 days and take 40 days to pay your bills.
Your Cash Conversion Cycle will be: 20 + 15 – 40 = negative 5 days.
This is awesome, and the sign of an extremely healthy business.
Thanks for reading…
by MHolland | Apr 18, 2024 | Accounts Payables, Accounts Receivables, Business Tips
Your monthly financial statements tell you a story….in the language of numbers…
Every business has three main financial statements:
- The Balance Sheet
- The Income Statement
- The Statement of Cash Flows
The Balance is the main statement. What? Not the Income Statement?
Yes, it is true that most businesspeople will focus most of their attention on the Income Statement.
They do this because the Income Statement shows the results of activities over a period of time – a month, a quarter, a year.
The Balance Sheet has all the information to determine the heath of a business at a specific point in time.
Did you know that the Income Statement and Statement of Cash Flows are each derived from the Balance Sheet?
The Balance Sheet is the fulcrum of the three statements.
The Big Picture
The story that your financial statements are telling you starts with the big picture.
Let us break it down…
Your Balance Sheet has three main sections:
- Assets
- Liabilities
- Equity
Assets are what you own.
These can be further segregated into Current Assets, Fixed Assets, and Investments and Intangible Assets.
Liabilities are what you owe.
They can be segregated into Current Liabilities (due within one year), and long-term liabilities.
The difference between your assets (what you own) and your liabilities (what you owe) is your equity.
A simple way to envision this – imagine all you own is a house. You paid $300,000. This is your asset, what you own. You have a mortgage of $210,000. This is your liability, what you owe.
Your equity is simply the difference between the two, or $90,000 in this example.
You sell your house for $300,000 and pay off your mortgage of $210,000 and you pocket $90,000.
Simple!
Your Income Statement is made up of two main sections – revenue (the inflows into your business), and expenses (the outflows from your business).
The difference between the two is your Net Profit.
Recap
So, now we have a Big Picture emerging – by knowing these five main sections of these two financial statements.
By looking at the Balance Sheet, we can determine what we own (assets), what we owe (liabilities), and the difference between the two (equity).
In examining the Income Statement, we can see what revenues flowed into our business, and what expenses flowed out of our business, and lastly how much profit we made.
That is the Big Picture…
Now let us get more detailed…and talk about ratios…
Ratio Analysis Deepens the Story
By looking at ratios in your business, we can start to interpret the “story of your business.”
Ratios come from the main sections of your financial statements. They tell us specific details about your business that we cannot glean from just looking at the five main sections…
By understanding exactly what they mean we can determine the overall health of our business.
From there we can make decisions to improve it.
What are the main ratios we should be looking at for most businesses?
Liquidity Ratios
Liquidity Ratios provide an early warning for a business unable to meet its current liabilities when they come due.
A current liability is defined as something due within one year. These include things like wages payable, accounts payable, taxes payable, and loan payments.
A current liability is paid with a current asset. Current assets are either cash in the bank or things that will convert to cash quickly. For example, accounts receivable collected and inventory when sold.
The current ratio is simply your current assets divided by your current liabilities.
One rule of thumb is that a current ratio of 2:1 or greater is extremely healthy.
A 2:1 current ratio means that for every $1 in current liabilities you have $2 in current assets to pay them. It means you are liquid.
Another way to think about it is that by being liquid you have enough current assets to pay your current liabilities as they become due.
By having $2 for every $1 in current liabilities means you are well covered.
Now let us look at…
Profitability Ratios
Three important profitability ratios are:
- Gross profit margin
- Net profit margin
- Return on equity.
Gross Profit Margin
Gross profit margin is the amount of profit left over after deducting your direct costs of producing or purchasing your goods and services.
Gross profit is needed to pay for your operating overhead. It needs to be high enough to cover all your overhead plus a profit.
Every industry will have a different gross profit margin percentage that will be normal in that industry.
Things that can lower your gross profit margin to a dangerous level include:
- Sales discounting
- Inefficient production costs
- Venders for your purchases that are charging too much.
- Venders delivering goods with poor quality.
Every business must measure their Gross Profit Margin by product line. In this way, you can monitor which product lines are most profitable in terms of both sales volume and the gross margin percentage.
Things that can increase your Gross Profit Margin include:
- Price increases especially when there is no loss in sales volume.
- Outsourcing manufacturing especially to a low-cost jurisdiction.
- Eliminating quality issues in either production in house or from your venders.
Next, we will look at…
Net Profit Margin
Every business needs to have overhead to run. These are indirect costs that are usually fixed in nature.
Some examples of overhead include:
- Management salaries.
- Rent.
- Insurance.
- Office Supplies.
Your Gross Profit must be enough to cover all of these fixed overhead expenses plus your profit.
Ways to increase your net profit include:
- Turn fixed expenses (as much as possible) into variable expenses.
- Find venders who will give you the same result for less money.
- Outsource as much as you are able to low-cost jurisdictions.
One of the things that happens to all businesses over time is that the fixed costs creep upward. And they also can be sticky.
By “sticky” I mean when businesses enter into longer term contracts that bind them to certain requirements that may no longer be needed.
What can happen is that you incur a fixed cost that you needed in the past, and now no longer do.
By not frequently examining your vendor relationships and agreements you may find you have fixed costs that are no longer even being used.
These can include things as expensive as office leases (more people are now working from home for instance) or software subscriptions for former employees that were not cancelled.
Now we will examine…
Return on Equity
Return on equity is expressed as a percentage of how much the business is earning in relation to its owners’ equity.
It is calculated by dividing the Net Profit by the Shareholders Equity and then multiplying this by 100 to represent it as a percentage.
A higher percentage is of course better, and a measurement of the reward being earned for the shareholders’ investment risk.
In Summary
Looking only at the larger numbers in the five main areas of your financial statements – Assets, Liabilities, Equity, Revenues, and Expenses – can be difficult to see patterns.
By expressing them as ratios, often a percentage, and understanding what they mean you can start to guide your business better.
A great accountant is someone who will interpret the numbers for you. He or she is like your co-pilot and they can help you see things that are otherwise incomprehensible.
Next week I will talk about Activity Ratios and Leverage Ratios.
Thanks for reading….
by MHolland | Apr 9, 2024 | Accounts Receivables, Business Tips, Cash Flow
Selling something, whether a product or a service, and not getting paid is brutally painful.
Sloppiness in your billing process will cost you. The ultimate cost is not getting paid.
As I have written about many times before, the cost of a bad debt is more than the actual dollar value lost.
What do I mean?
Consider a bad debt of $1,000. Did you lose only $1,000? Yes, you did lose $1,000, however…
You need to recover that $1,000, right?
Let us say that your business sells computers. On average you sell a computer for $1,000.
The computer costs you $800. You have a Gross Profit of $200 ($1,000 less $800).
To recover that $1,000 lost as a bad debt how many computers do you need to sell?
Five. Yup, gulp, five.
How so? Do the math.
5 computers sold @ $1,000 each = $5,000
The cost of those computers is 5 @ $800 = $4,000
The difference is $1,000, which is your Gross Profit.
This $1,000 bad debt has now been recovered only after selling an additional 5 computers.
So, is the bad debt just $1,000, or $5,000? The bad debt expense is $1,000, that is correct.
However, to get back to where you were before you incurred this $1,000 bad debt you must sell $5,000 worth of computers. Ouch!
9 Principles of Managing Accounts Receivable
- Develop a clear, internal accounts receivable
- Understand your new
- Credit check your new customer
- Mutually agree terms with your customer before delivering goods or services
- Issue the invoice immediately after delivery of goods or services.
- Politely chase your customer before the invoice is due to ensure they are on track for payment.
- Continue politely and persistently chasing your customer for payment if they have not paid by the due date.
- Optional – for truly troublesome customers, go ‘nuclear.’
- Thank your customer for payment as soon as possible after receiving it.
4 Cornerstones of Your Accounts Receivable Procedure
- Schedule invoice chasing time every week.
Book the time out in your calendar in advance. Never cancel it, never miss it.
- Maintain invoice communications histories.
Log all communications with every customer about every invoice. Emails, phone calls, letters, meetings – log it all
We use an innovative program with our clients called Chaser. All communication gets logged in a portal for each customer.
- Regularly assess problem invoices
For larger businesses, this may mean holding credit control meetings. For smaller businesses, this should be covered in regular finance meetings. Always complete bank reconciliation on the day of the meeting to ensure you are working with the most accurate and up to date info.
We stay on top of our bank reconciliations for all our clients daily. For clients who pay by cheque it is critically vital to deposit cheques received within a day.
- Inform the business of bad payers!
If assessing problem invoices reveals customers with poor payment trends, let other departments in your business who have touch points with them know. This may be sales reps or account managers.
4 Questions You Must Ask New Customers
- What information do you need to make payment?
- Who should I speak to in order to settle payment on this invoice?
- When do you make your payment runs?
- What are your business details for invoicing purposes?
By getting answers to these 4 questions, you will avoid:
- Getting paid late.
- Having to re-do invoices, resulting in more internal labor costs.
In Conclusion
The software we use for many of our clients is called Chaser.
Here are some of the key features of Chaser (great name, isn’t it?):
- It will send out personalized emails that fit your style of business.
- It sends these emails in a structured timed way designed to remind your client to pay.
- It will send text messages.
- You can use it to make phone calls and the history of all communication (emails, texts, phone calls) will now reside in one portal inside the Chaser software.
Thanks for reading…
**NOTE this blog post was first published by me in May 2021. I have updated it and am re-publishing it due to the critical nature of good accounts receivable management in an economically challenging time…
by MHolland | Apr 3, 2024 | Business Tips, Selling Tips
The last three weeks I have written about the first five essential secrets to build a business that works…
To recap:
- Essential Secret Number One – You Must Have a Vision
- Essential Secret Number Two – There Are Only Four Ways to Grow a Business
- Essential Secret Number Three – You Must Have a Strategic Plan of Action
- Essential Secret Number Four – What you Measure, You Can Manage
- Essential Secret Number Five – Creating a Difference
This week, I will write about…
Essential Secret Number Six – Performance Standards
The secret is that most businesses have no standards. They just do it the way they learned in the past. It is not by design.
Consequently, there is no consistent pattern of performance that a customer can expect.
As a result, they experience something different every time.
This problem gets bigger as the business grows.
The solution is to create simple performance standards – created with your Team – that you can use as a tool for performance.
Even better – share them with your customers – and let them be the judge of how well you are doing.
Performance standards make it easy to manage your business – because now you can see when they are being done or not.
Performance Standards must be written down so that people can memorize or refer to them and new employees can be trained in them.
They must be simple and easily duplicated.
They can be managed.
For example – we have a very detailed set of performance standards to answer the phone.
One of the standards is to – “answer the phone on the second ring”.
This is a Performance Standard that is based in physical reality. It either is being performed, or not being performed. You can observe it and measure it in physical reality.
It is not an emotional, feel-good motherhood statement.
When anyone is not performing to the standard, it stands out like a sore thumb…
Performance Standards are designed to:
- Create consistency in the outcomes you are committed to produce.
- Give you a tool to train new people with.
- Create a culture that is bursting with energy and awesome service.
- Be measurable.
Essential Secret Number Seven – Systems
If you’re not working on your business, you are working in it.
The secret is to work on your business and create powerful simple systems that work. A great business has a system manual – it is the blueprint for “this is how we do it here.”
After you have your systems created, outsource everything you do not like or are not good at. That means the bookkeeping, the administrative work, the emails, the phone calls, the event management…. all of it!! Leave yourself the fun, inspiring and important work.
Systems, like Performance Standards, are designed to create a way of doing things in your business. This “way of doing things should be unique and designed to create high-quality outcomes for your customers/clients in your products, services, aftermarket service, and delivery.
The system is your business. Your business is the system.
Think of a franchise, like McDonalds. When you invest in the McDonalds business franchise, what you are truly investing in is their systems.
A business that is not dependent on systems, is by default dependent on you, and on your people.
The more time you spend working IN your business the lower the value of your business.
Why?
Because potential investors will see the amount of time you are putting into your business. They want to buy a system that will give them a consistent rate of return based on their investment, not their personal time investment.
Thank you for reading…
