By Tom Crouser
A good road map or GPS system tells where you are, where you’ve been, and where you’re going. Same with financials and why you want to understand them. Here are details.
While more information is better, tax returns may be used as a starting place. Better yet you might have a balance sheet and income statement maintained in QuickBooks.
The balance sheet shows what we have of a specific date, what we owe, and the portion of the business we own.
Reading it requires we understand current. Current is the next twelve months from the tip of your nose. Assets are what we have, and liabilities are what we owe. So, current assets either are cash or will turn into cash within twelve months. Cash, receivables, and inventory are examples.
Current liabilities, on the other hand, require cash today or will require cash within twelve months. Accounts payable, taxes due, wages payable or the portion of notes payable due within twelve months are examples.
Your current ratio is then total current assets divided by current liabilities. Desirable is a 2:1 current ratio or $2 in current assets for each $1 in current liabilities. That’s because current liabilities are due today while receivables and inventory, for instance, take longer to turn into cash.
So, this is the hassle factor. Businesses go out of business when their current ratio falls too low. This is the problem when we must run to the mailbox to grab checks to pay today’s bills. We’re under pressure to take every job no matter how low the price for some money is better than none. And owners of businesses with low current ratios rarely take real vacations.
Closely linked to the current ratio is days’ cash on hand. While this isn’t precise, it’s close enough. Assume sales are $365,000 per year, then that’s $1,000 a day. So, if you have $20,000 of cash on hand, you have 20 days’ cash (or 20 days’ sales in cash on hand). And, yeah, I know we’re not open 365 days, but let’s keep it simple.
You should have 30-days cash on hand and a 2:1 current ratio to be financially strong. Get there and stay there and there’s little chance you’ll go out of business.
Now the Balance Sheet is like the scoreboard at the end of the football field. It tells you where you are. The Income Statement, then, is like the instant replay. It tells you what happened during the last play.
To understand it, know that there are only three kinds of costs. Direct materials are paper, toner, solvents, and solutions. If we printed nothing, we would have no direct material cost. Direct materials vary directly with sales, but the percentage generally doesn’t change.
Next is wages walking out the door. This includes hourly wages, salaries, FICA, FUTA, health insurance, contract labor and any other cost associates with wages except owner’s salary. For the most part, wages are relatively fixed although they can vary some month to month.
Then there’s overhead. That’s everything which is not a direct material nor a wage. Rent, utilities, advertising, depreciation, repairs and maintenance are examples. Generally, these are fixed expenses which may also vary slightly, but generally are fixed from month to month.
So, what should these costs be? Benchmarks are 25% of sales for direct materials, 25% for wages, and 25% for overhead leaving 20%-25% income before owner’s compensation.
So, if you have a 2:1 current ratio, 30 days plus cash on hand, and 20% or more income before owner’s compensation, then you are a solid company. If you’re short of that, then you have work to do.
How do you get there? Use the income statement to create a budget.
If we have so much coming in (sales), then we can subtract direct materials, wages, and overhead as well as a salary for the owner, our plan to pay back loans we may have and then we see what’s left over. If we’re negative, we again have more work to do.
How do we know how much sales will be next year? No way to guarantee, but we’ll show you how we do it in our webinar, register or review recording here.
Hope you will be with us.
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Tom Crouser is chairman of CPrint International. Message him at firstname.lastname@example.org or call his cell (304) 541-3714.