The Current Ratio is used by short-term creditors to determine a company’s ability to meet short-term financial obligations. Short-term creditors prefer a high Current Ratio. Higher current ratios are an indication of lower risk and consequently, lower current ratios suggest higher risk.

The current ratio is calculated by dividing current assets by current liabilities:
(If you don’t know what Assets or Liabilities are, Check this out).

Current Ratio: Current Assets
Current Liabilities

Here are two examples:

EXAMPLE 1
Current Assets: $250,000 (this includes cash, inventory, accounts receivables, etc.)
Current Liabilities: $75,000 (this includes financial obligations that will be paid within the year)

$250,000 / $75,000 = 3.33 (This situation is less risky for short-term creditors)

EXAMPLE 2
Current Assets: $100,000
Current Liabilities: $125,000

$100,000 / $125,000 = 0.80 (This situation is more risky for short-term creditors)

One reason that you need to understand about this ratio is that creditors prefer a higher current ratio because it reduces risk BUT owners tend to prefer a lower current ratio because this could be an indication that more of the firm’s assets are working to grow the business.

Assets are things, that a company owns, that have value. An asset is also that which is owed to a company such as accounts receivables. Assets include tangible items such as buildings, vehicles, equipment, tools and inventory. However, tangible property is not the only thing that can be classified as an asset; intangibles such as trademarks, patents, research and development, and goodwill are also included in the category of asset. Remember that cash is an asset. So, anything of value that is owned or due to the business should be included as an asset on the Balance Sheet.

A liability is everything that a company owes others. This includes money that a company might owe a supplier, payroll that is owed to employees, taxes owed to local, state and federal tax agencies, and money owed to banks or other lending institutions for loans or credit card balances. This list is not all-inclusive as there are many financial obligations that fall in the liability category on the balance sheet. I have just included a few of the most common ones found on balance sheets of small businesses.

In a nutshell, Owner’s Equity represents the money that would available to all the owners if the company sold all of its assets and paid off all of its liabilities. Equity increases when owners invest money into the company and/or when the company shows a profit and retains those earnings in the company instead of paying those earnings out in a dividend. Equity is often called owner’s equity, shareholder’s equity, capital or net worth.

The following formula represents the balance sheet:

Assets = liabilities + Owner’s Equity

Understanding the balance sheet and monitoring its changes will help a business owner understand important trends in the business and help he/her make better decisions.

This is the question that I got from one of my clients after I asked him what his Exit Strategy was.

“I don’t plan on ever selling my business. This is what I enjoy doing and I’m going to hand it over to my kids when I’m ready to retire.”

That, my friend, is exiting your business. Whether you hand it off to your kids, sell it to the highest bidder or work in it until the day you die, (which essentially means you are handing it off to your kids) you are EXITING and you must prepare for that transition.

Here are some key items that need to be handled if you want to hand your business off to your kids.

• Make sure the business runs with predicable systems and doesn’t rely on only what’s in your head to function.

• Make sure your customers have a relationship with your business and not just you. This doesn’t mean they can’t have a relationship with you, after all, you are the business in their eyes. Your customers need to know that the business is providing the service and if ownership changes, the service won’t be compromised. Make the transition.

These are just two of the many things that you need to have in place before you exit your business. If you want to know the rest of the “to-do’s”, ask yourself this question.

If I were to be taken out of commission tomorrow, what needs to be implemented today so the business doesn’t skip a beat? If you can answer this question, create a list of action items, and check them off, your business will be in good shape for your exit…even if it is just handing it off to your kids.