Bob Valentine Ph.D.Article 3

Before we move on, I would like to discuss one more liquidity ratio.  Financial management is like math or a foreign language, if you don’t use it you’ll lose it.  Since we took July off you might want to do a quick review of the May and June columns.

The last liquidity ratio I want to discuss is the Cash Ratio.  If you remember I said in the May column, ‘Cash in an equine business is KING’.  Therefore, I call the Cash Ratio the Horsemen’s Ratio. 

The Cash Ratio formula is: Cash Ratio (Horsemen’s Ratio) = Cash + Cash Equivalents  / Total Current Liabilities

The Cash Ratio is the most conservative liquidity ratio because it excludes all Current Assets except the most liquid: Cash and Cash equivalents (Marketable Securities).  The Cash Ratio is an indication of a business’s ability to pay off its current liabilities if for some reason immediate payment were demanded.  Receivables and Inventory are eliminated from the Cash Ratio. If you remember, receivables are like ketchup and can be slow to collect and inventory is like molasses and very difficult to turn into cash (June column).   A Cash Ratio of 1:1 is good.  It means you can feed and care for your horses in difficult times.  It also means you have the opportunity to gain an advantage and be a much better business with the potential to gain market share from your competitors.

In your Chart of Accounts you may have to manage or at least monitor what is called Other Assets.  Other Assets include all Balance Sheet Asset Accounts not covered specifically in other areas of Asset Management.  Often, such accounts may be quite insignificant to the overall financial condition of a business.  Other Assets include accounts like: Deposits (utilities, telephone, etc.); Organization Costs (if you purchased your business); Accumulated Amortization of Organization Costs; Non-Current Receivables and Other Non-Current Assets.  Unless you purchased your business, you probably only need to monitor your deposits so they are released as soon as possible.  If they are sitting on your Balance Sheet, they are ‘Cash at Rest’.  Deposits do not earn interest (generally) and are not helping you grow your business.

In your Chart of Accounts your business's Long-Term Liabilities are accounted for by its debt obligations to other parties that last longer than one year.  However, remember the current portion of the debt obligation (due within a year) is accounted for in your Current Liabilities (June column).  Long-Term Liabilities include accounts like: Leases longer than one year (property, horses, etc.); Notes (loans from individuals, etc.); Land; Equipment (ranch equipment, tractors, ATV’s, balers, etc.); Vehicles (ranch truck, horse trailer, etc.); Bank Loans and Other Long-Term Debt.

Management of Long-Term Liabilities is critical in evaluating a business’s risk and its long-term solvency.  There are three important ratios used to evaluate a business’s risk and solvency.  They all include a business’s Long-Term Liabilities.  Long-Term Liabilities need to be managed to keep a business growing or from becoming insolvent.

Debt Service Coverage: Is a measurement of a business’s ability to generate enough cash flow to cover its debt obligations.  This ratio needs to be greater than 1 (DSCR > 1).  If it isn’t greater than 1, the business needs to improve its profit or reduce its long-term debt.  DSCR is income before income taxes + depreciation + amortization + interest / repayment of its debt obligations this year + interest. 

DSCR = Net Operating Income  / Total Debt Service

Total Debt to Assets: Is a measurement of a business’s relative obligations.  The Debt to Assets Ratio is not a particularly exciting one, but it is very useful.  The ratio needs to be less than 1 (DAR < 1).  If it isn’t less than 1, the business needs to reduce its debt load or put tighter controls on its purchasing.  Loan institutions will interpret a high ratio as a ‘highly debt leveraged business’. Businesses with high ratios are placing themselves at risk, especially in high interest rate markets.  Creditors are bound to get worried if a business is exposed to a large amount of debt and may demand that the business pay some of it back.  DAR is Total Liabilities (current and long-term liabilities) / Total Assets.

Debt-Asset Ratio = Total Liabilities  / Total Assets

Total Debt to Equity: Is a measurement of a business’s leverage.  This is a more stringent measurement of a business’s financial risk than its 'Total Debt to Assets' ratio. The ‘Debt to Equity’ ratio is also called the ‘Debt to Net Worth’ ratio. It quantifies the relationship between the capital invested by a business’s owner(s) and/or investor(s) and the funds provided by its creditors - the higher the ratio, the greater the risk to a current or future creditor.  A ratio greater than one (DER>1) means assets are mainly financed with debt and less than one (DER<1) means equity provides the majority of the financing.  A lower ratio means your business is more financially stable and is probably in a better position to borrow now and in the future.  However, an extremely low ratio may indicate that you are too conservative and you are not letting your business realize its full potential.  If the ratio is greater than 1, the business probably needs to improve its profit, get additional investment or sell off unproductive assets (May column).  Creditors will interpret a high ratio as a ‘highly debt leveraged business’. Businesses with high ‘Debt to Equity’ ratios have the same interest rate exposure and creditor scrutiny as a business with a high ‘Debt to Asset’ ratio.  DER is Total Liabilities (current and long-term liabilities) / Shareholders Equity.

Debt-Equity Ratio = Total Liabilities  / Shareholders Equity

In our next column we will discuss Equity in a horse business and expenses.  I suggest you do a Cash Ratio (Horsemen’s Ratio) even if you don’t operate as a business.  Remember, spending your money wisely may provide the opportunity to attend another horse show or event or do something special with your horse.   Think – plan – organize – execute – make/save money.

‘If you can’t measure it, you can’t manage it.’

Bob Valentine, Ph.D.
President
GenieCo, Inc.
1/888.678.4364
bob@genieatwork.com
www.equinegenie.com

GenieCo, Inc. was founded by Bob Valentine, Ph.D.  Dr. Valentine has been breeding horses since 1971.  He is also a professor at Colorado State University where he teaches Equine Business Management to graduating seniors in the Equine Science Department.  In addition, Dr. Valentine writes a monthly equine business column titled: ‘Mind Your Own Business: Think – plan – organize – execute – make/save money’.  The monthly column is published in several equine newsletters and publications.

GenieCo, Inc. is a Colorado Corporation and a member of the Rocky Mountain Innovation Incubator (RMI2). GenieCo Inc. specializes in providing Intelligent Business Systems for individuals and small to large business owners.  

Bob is available to discuss your equine business free of charge by contacting him at, bob@genieatwork.com, or calling him at 1/888.678.4364.