Liquidity Ratios: Trends Key to Profitability Outlook
Originally published: 05.01.12 by Ruth King
Graphing balance-sheet data points will reveal potential pitfalls.
Every month you should receive accurate and timely financial statements. Looking at one month’s financial statements (balance sheet and P&L statement) does not tell much. To see where your business is headed, you must look at your business trends. Then you can choose to continue on the current path or make the necessary changes to alter the direction of the business.
Graphing the trends also gives you a snapshot of the direction of your financial ratios, sales, profits, and overhead. I wrote about the 10 financial ratios I track each month (see HVACR Business, Sept., 2011). This month I will concentrate on the liquidity ratios. In future months I will discuss the trends for the other seven ratios.
There are three measures of business liquidity, i.e., can you pay your bills? These are:
- current ratio;
- acid test or quick ratio; and,
- accounts-receivable to accounts-payable ratio.
These are found on the balance sheet, the financial statement that most contractors ignore. However, by the end of this article, you’ll see why you must pay attention to the balance sheet.
An increasing current ratio generally means increasing profitability. A decreasing current ratio generally means decreasing profitability.
Table 1 shows the actual 10 ratios that I track each month for a contractor. It is hard to decipher what is happening in this company just looking at the numbers. Graph 1 shows the current ratio, acid test, and accounts-receivable-to-accounts payable ratio for a contractor. You can make sense out of what is happening with the company as you look at the graph of the data. When you look at Graph 1 you can see the seasonality of this business. The current ratio and the acid test increase and decrease as profitability increases and decreases during busy and slow months.
The current ratio and the acid test should also mirror each other as they do in Graph 1. This means that the distance between the two graphs remains about equal. When this happens your gross margin is consistent on a month-to-month basis. If the spread between the current ratio and the acid test were increasing, that would mean that inventory is increasing. An increasing spread between the two ratios should be a warning sign. Why is inventory increasing? If it is because of a pre-season purchase, then you should expect the spread to increase for a month or two. If employees are buying too much inventory in relationship to what the company is using on jobs, you’ll see this because the spread between the two ratios will increase.
The accounts-receivable-to-accounts-payable ratio also varies according to seasonality. I will discuss this ratio further in a future month because the receivable days impact this ratio.
Table 2 shows the trailing data or the trend of the liquidity ratios. Each point takes one year’s data and divides it by 12. For example, March’s trailing current ratio point adds 12 numbers together: the previous February through the current March, and divides that sum by 12.
Graph 2 shows the trailing data for each liquidity ratio. It tells a very alarming story for this company. Their trailing data shows that the company is becoming less profitable on a long-term basis (the current ratio and acid tests are decreasing as are the accounts receivable to accounts payable ratio).
On a monthly review of the financial statements you can’t tell that the company is losing profitability. Only when you look at the liquidity ratios on a long-term trend can you see that the company must become more profitable each month to survive for the long term.
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