Can We Really Trust Accounting to Save Our Business?

As a small business owner, you may be very good at offense, bringing the money in, but terrible at defense, keeping track of it and using it as an asset to grow your business. You intuitively understand that cash-on-hand and liquidity can be super important for your small business, but may have been too busy working on your business to think much about it.

photo credit: Ken Teegardin

Do You Know Your Numbers?

If you only remain good at offense, your defense may let you down – and you lose the game…although it appeared that you had everything working for you. That’s what happened to Lehman Brothers. This was the fourth largest investment bank in the country and a global financial behemoth. Yet, on September 15, 2008, despite $600 billion in assets, they filed for bankruptcy. Embarrassingly, this was the biggest bankruptcy filing ever in the history of the United States. How did this happen? They made a simple mistake in math–expenses exceeded income, money flowed out faster than it flowed in, and the business became unsustainable.

The lesson here: pay attention to working capital because even the mighty can fall. The simple truth is that no business is too big to fail.

Think Like An Investor

Working capital is the money you have available in your company to keep the lights on, run the machines, and put people to work. It supports your daily operating costs. Like an antivirus program on your computer’s hard-drive, it runs unobtrusively in the background, and the only time you probably pay attention to it is when it stops working and things start to go wrong.

Should you run out of working capital, you will have to pack the items in your desk drawers in a cardboard box, go home, and ponder a new future.

Do you think a brief overview may be useful in avoiding unexpected setbacks to your business?

The best way to understand the value of why you should be highly interested in working capital is looking at it from the point of view of an investor.

If you were thinking of selling your business to an investor, do you think they would be satisfied with a walk through of your office, a brief conversation with your happy employees, and the fact that each cubicle looks like it got its computer technology from NASA.

No, an investor is not interested in the bright and shiny appearance of your business. (Lehman brothers had one of the most impressive buildings in New York.) They want to take a look under the hood. An investor would rather look at your books than make an office visit. They want to know about your working capital and your liquidity. How financially healthy are your company’s short-term assets? How easily can everything be converted into cash. How much do you know about liquidity management?

photo credit: Alan Cleaver

A Simple Account Formula

Working capital can be understood with a simple accounting formula:

Your current assets minus your current liabilities equal your working capital.

If your current assets exceed your current liabilities, you will have positive working capital. If your current liabilities exceed your current assets, you will have negative working capital.

This is what an investor will look for as he scans your accounting balance sheet. Do you have more inventory, accounts receivable, and cash-on-hand than you have lines of credit, bank loans, notes payable, accrued expenses, and accounts payable?

If the numbers work out, it means two things: you have a healthy business and it’s run efficiently. All this good news is reflected through the lens of your positive working capital.

Another Important Accounting Formula

Another way of reviewing your books would be to look at the working capital ratio

Again, working capital ratio can be understood with a simple accounting formula:

Your current assets divided by your current liabilities equals your working capital ratio.

If the ratio is 1.0 or above, your business is in good shape because it indicates that you have a positive working capital. However, if your ratio is less than 1.0 than your business is out-of-shape because it indicates you have a negative working capital.

At this point, you can be forgiven for thinking that the higher you are above 1.0, the healthier your business. Actually, while a high-working capital ratio does indicate that you are not flirting with bankruptcy, if it is too high, it indicates that you are running your business inefficiently because your money is not making money (i.e. you are not optimizing your excess capital.) The ideal ratio will vary from one company to another and from one industry to another, but, generally speaking, it should be between 1.2 and 2.0. Beyond that ratio, it means you are not putting your money to work to grow your business.

Accounting in action
photo credit: foam

Putting It All Together

An aggressive offense and a solid defense is great, but only with both working in tandem do you have a winning business model. Although you would probably rather spend most of your time doing what you do best – branding, marketing, and direct sales – it’s important to grasp two simple accounting principles to make the best use of all the money you’re making.