This is where I share the story of creating my own bag brand, Po Campo.
It’s not as obvious as you may think to tell if your business is doing well. For examples, sales can be rapidly increasing, which feels like things are going great, until you find out that expenses have been outpacing the sales, in which case you’re back to where you started from. I’ve been there and it stinks!
Having strong financials is not the only characteristic of successful companies, but they certainly make running and growing a business easier. With my background in industrial design, I always thought as “financials” as someone else’s job, so it took me several years to get a good handle on what my financial statements were telling me and how I could make business decisions based on them. Once I became familiar with the Profit & Loss Statement (also called Income Statement) and Balance Sheet, I started using standard financial ratios to help me understand how my company was performing compared to other companies in my industry. Learning how Po Campo stacked up against other small companies (here defined as manufacturers with sales under $5 million) helped me understand how to move the needle towards a stronger financial profile.
My five favorite ratios are:
1. Current Ratio = Current Assets ÷ Current Liabilities
Definition: We all need money in the bank to make sure we can pay all our bills when they come due. The current ratio measures the “safety margin” that you are maintaining to cope with the ebbs and flows of cash.
What’s normal*: 6.4
If your current ratio is less than this, that means a surprise expense could impair your ability to pay your bills, which is risky. If your current ratio is greater than this, that means your socking away an above-average amount of money, which is more comfortable. My number is much smaller than this, which explains why I’m so stressed when I think about money!
Where you find these numbers: Both the current assets and current liabilities are on your balance sheet.
2. Quick Ratio = (Cash + Accounts Receivable) ÷ Current Liabilities
Definition: The quick ratio measures the extent to which you are able to pay your current obligations (read: bills).
What’s normal*: 2.5
Similar to the “current ratio”, if your number is less than this, you are operating a little too lean and if your number is greater than this, you are operating at a more comfortable level.
Where you find these numbers: Cash (and Undeposited Funds), Accounts Receivable and current liabilities are all on your balance sheet.
3. Accounts Payable to Inventory = Accounts Payable ÷ Inventory x 100
Definition: This ratio tells me to what extent my inventory is being financed by my suppliers rather than being financed by cash flow or traditional debt.
What’s normal*: 16.8
If your ratio is higher than this, it means that your supplier is financing most of your inventory. This could be okay if you have a good relationship with your supplier. It does give them more leverage over you, as they are essentially your bank, so just make sure you’re comfortable with that.
Where you find these numbers: Both Accounts Payable and Inventory are listed on the balance sheet
4. Debt to Equity = Total Liabilities ÷ Net Worth
Definition: This ratio tells me the balance between debt and my equity.
What’s normal*: 0.1
If your number is lower than this, that means that a greater proportion of your business if financed by the owners, which generally means you have fewer financial obligations but also means that your growth may be restricted by how much the owners are willing to finance.
Where you find these numbers: Once again, this is on the balance sheet.
5. Times Interest Earned = (Profit Before Taxes + Interest) ÷ Interest
Definition: TIE measures the number of times profit (before interest and taxes) will cover your interest payments. It helps you know to what level your income can decline without hurting your ability to make your interest payments.
What’s normal*: 0.5
The higher the number on this ratio, the better! But as long as you’re above zero, you will be making your interest payments.
Where you find these numbers: On you P&L (Profit & Loss), take your Net Income and deduct taxes and interest, and then divide that number by the interest.
Good luck with calculating your ratios! Remember, building a business is a #practice, so just try to improve month by month and quarter by quarter. Rome wasn’t built in a day.
*How do I know what’s normal? As a member of the Outdoor Industry Association (OIA), I received a copy of their 2013 Manufacturer Benchmarking Report that “presents a detailed but straightforward analysis of the financial and operating characteristics and compensation practices of outdoor manufacturers”. And boy does it ever! Read a topline of this report here.