Liquidity: looking at the short term
The key measure of short-term survivability is liquidity; a metric indicating the amount of spendable money - including assets that can easily be converted into cash - that can be used to manage immediate debts.
Measuring liquidity is usually done in one of two ways.
1. Current ratio
The first is the simplest: the current ratio. This is calculated by dividing an organization’s current assets - cash and anything that can be converted to cash within 12 months - by its current liabilities, which are any financial obligations that need paying within 12 months.
2. Quick ratio
A more accurate option is the quick ratio, which is calculated by taking the value of an organization’s inventory and its prepaid expenses away from its current assets. This figure is then divided by its current liabilities. In both cases, a result below one is troubling. Ideally, a healthy organization will aim for a ratio above 1.5.
Solvency: looking at the long term
While liquidity measures an organization’s ability to pay off its debts in the short term, solvency is focused firmly on the long term. This metric changes more slowly than liquidity, but it also varies a lot between industries, so businesses will need to do some research to understand what number they should be aiming for in their particular sector.
3. Solvency ratio
To get a simple indicator of solvency, a company’s total liabilities can be divided by its total assets. However, the most common metric used in this area is the solvency ratio, which is calculated by adding an organization’s net income (after tax) to its non-cash expenses, and dividing the result by its total liabilities.
The result can be expressed as a decimal, but it can be a good idea to convert it into a percentage. This can then be thought of as the percentage of an operation that is actually owned by its operator, giving a good indication of how healthy it is overall.
How to measure efficiency
To gain a fuller understanding of a organization’s health, it’s necessary to look at its efficiency. This measures how well an organization is using its resources in order to generate profit and is the basic function of a company, making this one of the most important metrics available.
How you measure this will vary depending on what type of business you are.
4. Inventory turnover ratio
For example, for a business that sells physical goods to customers, an important measurement is its inventory turnover ratio, calculated by dividing the cost of goods sold by the average inventory over a given period. The higher the number, the better the organization is at producing the right amount of product to meet customer demand.
5. Receivables turnover ratio
For service-based businesses, it might be better to use the receivables turnover ratio. To calculate this for a given period, take the net credit sales for this date range and divide them by the average accounts receivable for the same period. The result will give an indication of how efficient a company is at collecting money owed to it; the higher the result, the more healthy the business could be seen to be overall.
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