There was a time not long ago when most investors relied on a company’s financial statements to determine whether the entity was in good economic health. The fact that this Warren Buffett type analysis is somewhat time consuming, has led many down the beaten path of technical analysis, the evil twin of financial analysis. Magic elixir is sold on the internet every day, explaining to you how you can look at a picture of a chart and, like a Ouija board, determine a company’s financial future.
There are a handful of traders who make a living with this method, but more make money by virtue of selling you their secrets. The segue here is that you should understand your own financial statements, particularly those that relate to liquidity, so down the road when you jettison your company, you will know what it is worth.
In the meantime, perhaps the most valuable portion of financial statement analysis to your business is in understanding cash flow and liquidity. So what is liquidity and why is it so important? Generally speaking, liquidity is the ability of an enterprise to generate sufficient cash to meet their own firm’s required cash needs in order to properly operate their day-to-day business. There is something called the Cash Conversion Cycle, where the conversion of raw material purchases, product development, product sales, and cash collection are in aggregate sufficient to keep your company afloat.
From a creditor’s point of view, it really is all about short-term liquidity. Why would someone give you credit or allow you to make payments if they knew you wouldn’t be able to pay them back? You should know the metrics used by those that grant you credit, so you can keep in good standing. This is what they look at when deciding if and how much money to extend.
There are three ‘key’ liquidity ratios, of which all of their components are found on a standard balance sheet.
- Current Ratio: The current ratio compares all of a company’s current assets to its current liabilities. These are usually defined as assets that are cash or will be turned into cash in a year or less, and liabilities that will be paid in a year or less. The greater the current ratio, the better, meaning the more money you have available to cover your current expenses.
- Quick Ratio: The quick ratio is an indicator of a company’s short-term liquidity position and measures a company’s ability to meet its short-term obligations with its most liquid assets. This is also referred to as the Acid Test.
- Net Working Capital: This calculation is used to designate the amount by which current assets exceed (or are less than) current liabilities. The difference between this calculation and the ratios above, is the net working capital is a dollar figure, not a ratio or a number of times covered figure.
The Cash Conversion Cycle and knowledge of these ratios will keep you abreast of how you are performing on a cash basis. Remember, in the short-term, cash is key, so evaluate these numbers every several weeks to stay on your toes.