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The Secret Ingredient to Understanding Your Numbers

What Are Numbers to Most People?

Many people have mixed reactions to numbers – some hate them, others are confused by them, and everyone loves money in the bank!

Some people fake it, pretending they know what they mean so as to avoid looking dumb.

I am one of those who loves numbers. I admit I am a little OCD with them. I play with them all the time. I am constantly counting – in the shower I will add the rows and columns of tiles to get the total. I cannot watch a train go by without counting the number of cars. When driving I add up the numbers on license plates, dropping the 9’s (ask me!) and seeing what the final number is. I know my 16 digit MasterCard number plus expiry date plus the 3 digit code on back by heart. To relax after work I play Sudoku, a Japanese numbers game! Ok, you get my drift…

Yet, even for a numbers guy like me (got this honestly, by the way, from my mom who was one of Canada’s first Comptometer operators – the forerunner of the computer), I go cross-eyed looking at black and white pages of numbers.

And isn’t this how most financial reports are presented?

I need color to make sense of it, otherwise it leads to…

Information Overload

A Balance Sheet and an Income Statement are broken down into sections, and between those sections are rows and columns of numbers.

Good financial analysts will take these reports and with a calculator start creating a way to understand the hidden gems – the story living inside these columns of numbers.

In a glance, take a look at this and tell me what it means in 5 minutes or less:

 

 

 

Just a bunch of boring, meaningless numbers, right?

 

Well, there is actually a story here and a way to condense this complex information and to shed light on what it all means.

So, what is the best way to…

Make Sense of It All?

The secret ingredient is ratios – condensing all these numbers into a few key ratios, and then getting educated as to what they mean.

An analogy here may be helpful. In medicine a doctor will measure a bunch of things (the equivalent to our ratios here). She/he will measure your blood pressure, weight, heart rate as an example of some of the basics. She will then know how to interpret them as a package of statistics based on their knowledge and on what they expect them to be and your specific history!

In other words, a number is useless by itself.

To make sense you must have two things…

Understanding and Education

You must understand what your ratios mean. And this is where an accountant who is a good communicator is vitally important. Your accountant should be educating you on exactly what your key ratios mean.

Let me give an example. Your Balance Sheet lists at the top, line-by-line, all your current assets. Somewhere in the middle in another section it lists, again, line-by-line all of your current liabilities.

What is this telling you? Not much – yet.

Firstly, what is a “current asset” and a “current liability”. You need to break down each term. Firstly, an asset is something you own, and a liability is someone you owe money to.

A “current liability” means it is due to be paid within 1 year.

A “current asset” means it will be either converted to cash or used-up (expensed) within one year.

So, how to make sense of this and bring some focused meaning to all these numbers making up current assets and liabilities.

Two ratios – one is called a Current Ratio, and the other a Quick Ratio.

The Current Ration is calculated by dividing your Total Current Assets by Total Current Liabilities.

So now what to do with this number? How do we interpret it?

I will tell you if someone gives me my BMI, (body mass index), I have absolutely no idea what that number means!

This is where education comes in.

Coming back to our Current Ratio – here is what it means. A Current Ratio of 2.0 means this – for every $2 in current assets you have $1 in Current Liabilities.

Now let’s go deeper – what does that mean? That means that if you were to convert all your Current Assets to cash (accounts receivable, inventory), and then you paid off all your Current Liabilities you would have $2 to pay every $1 in current liabilities. In other words, you would pay off all your current debt and still have money left over ($1 for every $1 spent on paying off your current liabilities).

What a Current Liability tells you is your ability to meet your current obligations as they become due.

A higher number is usually better. If the Current Ratio is less than 1.0 then you will not enough current assets to pay your current obligations and you could run into a serious cash crunch and need to inject your own capital into the business.

Goals and Targets

Now that you know what your Current Ratio means – you can set a goal or a Target. You may want to have a goal of a current ratio of 2.0.

And you now know what it means, and what you have done is taken all those numbers in the Current Assets and Current Liability section and condensed that complexity and overwhelm into a meaningful, trackable number.

Once you have a deep understanding (and a good accountant constantly reminding you what each ratio means) of the ratios, you can create a dashboard of these Key Ratios to monitor and track your financial results.

Here is one example of a Dashboard we use with our clients to summarize the key ratios:

 

This provides a simple visual of a complex set of black and white numbers. The coloring is simple and easy to understand – green is good, red is bad. You can see in an instant the 3 ratios that are red, and if you don’t understand what they mean you can ask questions.

You can eliminate ones that don’t fit your business and add a few that do.

 

 

 

Benchmarking Versus Targets

I prefer self-set targets to benchmarking to others in your industry for a couple of reasons – firstly you know best what you want to aim for in your business.

Comparing to others is not that fruitful. Set your own goals!

Also, the biggest trap of benchmarking is that the numbers you are comparing to are averages, so you are comparing yourself to the middle of the pack, not the best performers.

To Summarize

Finally, let me summarize…

First, with the help of a good accountant, educate yourself as to what a bundle of key ratios mean.

Together, decide which ones are most meaningful for your business.

Add ones that you think are missing. You can make up your own ratios!

Get help from an accountant who is good at understanding ratios and communicates well to explain what they mean for your business.

Set goals for your ratios now that you understand what they mean.

Track them monthly, or even more depending on the ratio.

Thank you very much for reading…