Many small businesses do not know the answer to that fundamental question.
It is technically illegal to trade while insolvent, but many small businesses do it every day, often without knowing.
So how do you measure “solvency”?
Being solvent means you are able to pay your bills when they fall due, but measuring it exactly involves a little judgement and understanding of the commercial circumstances of the business.
However, there are two simple measures almost always used by a lender, or anyone else with a need to check the health of your business.
Both are about the manner in which you manage your cash, which should be right on the top of any management agenda irrespective of the size or complexity of your business.
1. The current ratio.
The current ratio is the first calculation a prospective lender will do , it is pretty easy to calculate, and most bookkeeping packages have it as one of the standard reports available.
Current ratio = Current assets / current liabilities
“Current” in a accounting speak means less than a year, so your current assets include cash, inventory at sales value, accounts receivable, and any short term investments you may have.
Current liabilities are those bills that will have to be settled within the same year. This number is accounts payable, short term maturing loans to be repaid, and the one many miss, the provisions for an accrued liability you may have for things like employees long service leave and other benefits.
2. The “Quick” ratio.
The second commonly used ratio is the “Quick ratio”, which as implied, is a measure the very short term ability to cover debts. Many businesses have a lot of money tied up in finished goods inventory, work in progress and raw materials. All can be challenging to liquidate in a short time, so the quick ratio is a simplified ,measure of the immediate ability to pay the bills.
Quick ratio = (Current assets – Inventory) / Current liabilities.
These ratios are the same apart from the inventory valuations and provisions, and are usually used together.
The valuation of inventory is always a challenging question.
In valuing finished good inventory for a “quick” calculation , the appropriate number is the realisable value within a month. If you have three months inventory on hand, it is unrealistic to believe you can sell it all in a month and get full price. Valuing WIP and raw materials inventory is even more difficult, as who wants a half completed product, and suppliers will be very reluctant to take raw material back at full invoice value.
As noted, these ratios are virtually always used when seeking funding, by any means. The potential funder will look at both ratios before any other detailed discussions. A bank will generally require a quick ratio of at least 1:1, and preferably 1: 1.1 or more, depending on their lending policies.
Are you trading illegally?
Do you know?
