In this episode: How do you know whether reinvesting in your business is the right move? Jon Peyton walks through the financial ratios that reveal a company’s health, profitability and efficiency, from the current and quick ratios to profit margin, return on equity and how fast you collect what you’re owed. He explains why buyers and investors will look at the same numbers.
Key insights
- Health ratios show whether you can meet near-term obligations: the current ratio, and the quick ratio or months of cash on hand.
- Debt isn’t bad if what you borrow earns more than it costs. Watch your debt-to-asset ratio.
- Compare your profit margin with your industry. Below it, find the leak; above it, protect and invest in your edge.
- Investors look at return on equity to see how quickly they’d earn back what they put in.
- The faster you collect receivables, the faster cash can go back to work. Days to collect over 30 is a warning sign.
Episode timeline
- 0:00 Is reinvesting in the business the right move?
- 2:16 The current ratio
- 5:00 The quick ratio and months of cash
- 7:03 The debt-to-asset ratio
- 7:25 When borrowing makes sense
- 9:28 Net profit margin versus your industry
- 11:20 Return on equity and investors
- 14:36 Receivables turnover
- 20:17 Days to collect and collections
- 21:55 Inventory and asset turnover
- 24:04 Using ratios to plan for growth
- 25:03 Why ratios matter at sale time
The episode in brief
Different businesses, different ratios. An inventory- or asset-heavy business will lean on different ratios than a service business. But some ratios matter for almost everyone, and Jon groups them into health, profitability and efficiency.
Health: can you meet your obligations? The current ratio compares current assets, such as cash and receivables, with liabilities due over the next 12 months. A ratio above one is a good rule of thumb. The quick ratio looks only at your most liquid assets: how many months of expenses could your cash cover? Jon suggests four months in strong economic times and up to six when a slowdown looks likely.
Debt can be a tool. The debt-to-asset ratio shows how much of your growth is financed by debt. If you can borrow at 6% or 10% and invest in something that returns 20% or 25%, debt can accelerate growth. Investors and buyers will look at how debt-heavy you are and how well you’ve used it.
Profitability: margin and return on equity. Net profit margin is net profit divided by sales: $100,000 of profit on $500,000 of sales is a 20% margin. Whether that’s good depends on your industry. If peers earn 25%, look for the leak. If they earn 10%, understand your edge and invest in it. Return on equity measures profit against the owners’ investment, and an outside investor will use it to judge how quickly they’d earn their money back.
Efficiency: how fast cash comes back. If customers can take 30, 45 or 60 days to pay, your receivables can tie up months of revenue while your own bills keep coming. Track how many days it takes to collect. Under 30 is healthy, and closer to 21 is even better. Beyond that, look at who pays late, tighten collection policies and consider early-payment discounts. Inventory and asset turnover ratios show how efficiently you use what you own.
Ratios reveal where money is misplaced. Are you over-invested in real estate and short on staff? Is machinery sitting idle because you can’t afford people to run it? Ratios can point to the answer.
Buyers will look at these numbers. If you ever want to sell or bring in investors, they’ll study these ratios. Weak numbers invite fire-sale offers. Strong ones support the exit price you need to fund your personal goals.
Key action items
- Calculate your current ratio and months of cash. Do it this month, then track both every quarter.
- Compare your net profit margin to your industry. Find a benchmark and note whether you’re above or below it.
- Measure your days to collect. If it’s over 30 days, review payment terms, follow-up and early-payment incentives.
- Test any borrowing against the return. Before taking on debt, estimate whether what you’ll fund can earn well above the interest cost.
Listen next: Episode 30: How Successful Entrepreneurs Distribute Money to Build Personal Wealth
Value Creation Consultancy™ has since merged into Founder’s Accounting™.
This episode is educational and isn’t legal, tax or financial advice. Speak with your own attorney and advisers about your situation.