Metrics to Help You Manage Cash¹
Metrics are very useful tools in helping you manage your business. They allow you to compare certain metrics to prior periods of time and also to industry benchmarks. The following metrics assist you with managing your cash or assets that can be quickly converted into cash, like Accounts Receivable and Inventory.
The Quick Ratio is a way for you to measure how much of a company's assets can be converted to cash in case it is needed to pay an obligation very quickly. The formula for the Quick Ratio is:
Quick Ratio = Liquid Assets / Current Liabilities
Liquid Assets are assets that are more “liquid” meaning they can be converted into cash very easily. An example would be your Accounts Receivable balance. An asset that would not be very liquid would be real estate because it would theoretically take longer to convert a piece of real estate into cash.
Let’s say that the XYZ Company has Liquid Assets of $100,000 and Current Liabilities of $75,000 then, using the formula, it’s Quick Ratio is:
$100,000 / $75,000 = 1.3, sometimes written as 1.3:1
Any ratio above 1 means that it is likely the company will be able to meet its short term obligations. Often, investors and lenders will pay attention to the Quick Ratio of a business and they are wary of lending or investing in a business that has a Quick Ratio of less than 1. This would indicate that the company already has a hard time meeting its current liabilities.
Accounts Receivable Turnover
The Accounts Receivable Turnover Ratio is a way to gauge how well your Accounts Receivable, or A/R, is being paid off. The formula for the Accounts Receivable Turnover is:
(Net Credit Sales) / (Avg. Accounts Receivable Balance) = Accounts Receivable Turnover
Let’s say the XYZ Company, for 2017, had a total of $200,000 in sales that were sold on credit, this means that a total of $200,000 in sales were made where the customer did not pay at the time of the sale, they essentially opened up a “credit” account with the company. The Average Accounts Receivable Balance for all of 2017 was $150,000. By using the formula we can calculate the Accounts Receivable Turnover:
$200,000 / $150,000 = 1.33
The higher the ratio, the more quickly the company is being paid. So, for 2016, the company had an Accounts Receivable Turnover of 1.33. The goal for 2018 should be to exceed 1.33.
Inventory Turnover Ratio
A lot of cash can quickly be tied up in inventory. By using the Inventory Turnover Ratio, a company will be able to quickly tell if they have an excess supply of inventory by letting them know how often their inventory “turned over”. In an ideal situation, a company would buy 100 items in inventory and sell all 100 in a specific time period, they would not have any excess inventory nor would they run out of inventory. The formula for the Inventory Turnover Ratio is:
(Cost of Goods Sold) / (Average Inventory Value) = Inventory Turnover Ratio
Let’s say that the XYZ Company, for the year 2016, had a total Cost of Goods Sold of $50,000. They also took inventory each month and the average of their inventory was $30,000. Using the formula, they can find out what their Inventory Turnover Ratio is:
$50,000 / $30,000 = 1.7
This means that the company “turned” it’s inventory 1.7 times. The goal is to increase the Inventory Turnover Ratio. By increasing your Inventory Turnover Ratio, you are becoming more efficient at purchasing and managing your inventory which means you have less cash tied up in inventory that is not moving.