By Zakiyyah Bhamjee of the Tariro Foundation
During the past 5 weeks I have been representing the Tariro Foundation at the first Lionesses of Africa Accelerator Program - and what a privilege it has been. Throughout these sessions one of the reiterating messages coming from the room has been around the many hats which we must wear as entrepreneurs, be it sales, marketing, HR matters, and not forgetting accounting.
As an entrepreneur, you may not consider yourself to be as number savvy as a commerce graduate, however having an elementary knowledge of financial ratio analysis in your arsenal can only be of benefit.
Financial ratio analysis is often used by investors and financial institutions to obtain an umbrella indication of an entity’s financial performance in key areas. One of these areas being short term solvency or liquidity, which will be the focus of this piece.
Liquidity Ratios (i.e. The Theory)
The current ratio (aka the working capital ratio) is a metric used to measure liquidity, it is defined as a company’s current assets divided by it’s current liabilities. To fully understand this ratio one needs to know what current assets and liabilities are. As the word suggests, current assets and liabilities are those items that in the case of assets can be converted into cash within 12 months, e.g. accounts receivable, cash and cash equivalents and inventory, and in the case of liabilities are payable within 12 months, e.g. accounts payable, income tax liability and short term portion of long term borrowings.
Being the sagacious ladies that you are, you’re probably thinking that inventory is in some instances somewhat illiquid and cannot be easily converted into cash within 12 months. The quick ratio (aka acid test ratio) recognizes this and attempts to measure the ability of an entity to meet it’s obligations relying on more liquid assets. This ratio is calculated by dividing current assets less inventories by current liabilities.
A general rule of thumb for the current ratio is 2 to 1 (written 2:1) and for the quick ratio 1:1. A comparatively low ratio may mean that your company may have difficulty meeting your obligations and is unable to take advantage of opportunities that require cash; on the contraposition a comparatively high ratio is a possible indicator that your capital is being underutilized and you are hoarding assets that aren’t strictly necessary.
Ways to Improve Liquidity
There are two rather self explanatory ways to improve these ratios being managing your current liabilities better or increasing your current asset base, however do keep in mind that merely taking cash (current asset) to settle a creditor (current liability) keeps this ratio unchanged.
One of the goals is to generate cash, accounts receivables or inventory without having to spend cash or finance them with current liabilities (debt or payables), improved liquidity can be achieved through:
- Better accounts receivable management, e.g. invoicing sales daily, maintaining an age analysis and following up on outstanding debtors regularly, offering early settlement discounts in order to encourage debtors to pay and performing a credit check on new non cash customers in order to avoid bad debts;
- Sell slow moving inventory through a clearance sale;
- Service based companies e.g. accountants, lawyers, marketers, etc, work with clients on a project by project basis - look for ways to convert some of these clients to a retainer relationship where you are remunerated a set amount per a month;
- Revisit your pricing to ensure that the effects of rising costs have been considered and incorporated into your pricing model;
- Review your insurance, phone and other contract based costs annually to ensure you’re getting the maximum benefit out of your money;
- Save money on general expenses through forming a co op and buying supplies, e.g. stationery in bulk in order to take advantage of bulk discounts and then divvying them up amongst the members of the co op;
- Leverage your accounts payable and try to delay supplier payments for as long as possible (within the agreed credit terms.)
These are just my thoughts on liquidity and are undoubtedly not absolute. Please feel free to share your useful tips on managing liquidity with us and comment below. You are welcome to contact me directly should you wish to engage on this topic further. I can be reached on email@example.com
Zakiyyah Bhamjee CA(SA) is an Entrepreneur and the group financial manager of the Bhamjee Group of Companies and the Entrepreneurship Portfolio Head of the Tariro foundation. She is passionate about Africa and is making progress towards defining her role in the growth story that South Africa has to share with the world. She graduated at the University of Pretoria having completed Bcom (Hons) with Specialization in Accounting Sciences in November 2011, successfully passing the SAICA (South African Institute of Chartered Accountants) Qualifying Exam in January 2012 as well as the IRBA (Independent Regulatory Board for Auditors) Public Practice Examination in November 2013. She completed articles at PricewaterhouseCoopers, South Africa and qualified as a Chartered Accountant CA(SA) and Registered Public Accountant - RA in December 2014. She is involved in various PBOs and aid projects. Zakiyyah can be reached on firstname.lastname@example.org
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