By: Chris Lanchech
I’m sure that you know already that debt can be your worst enemy.
It comes down to this: Are you solvent? Or if you’re not, will you soon be? In other words, is your insolvency temporary? Can you turn things around quickly?
This is an issue that you must consider, the frequency of which will depend on your business and your circumstances. There are no hard and fast rules.
No doubt you have seen, in the past few years, many stories of companies that had been in business for decades, but that had to close down because they were no longer solvent.
It didn’t matter if their order books were full. When the ratio of debt to cash and accounts receivable passed a certain point, the banks closed them down.
There are a number of ratios that you can use to see just how healthy your company is, and your accountant will be the best person to discuss them with, but I just want to mention one of them. It’s called the Acid Test.
To calculate this key ratio, all you need to do is to add together your invoices and the cash you have on hand, and then divide that number by your current liabilities.
In other words compare what you can convert into cash quickly to what you owe in the time it takes you to make that conversion.
The number you get should be at least one. Anything less than that is a warning sign.
Although many creditors expect to be paid when they provide the service, others will give you a grace period of 30, 60 or even 90 days before contacting a collection agency. And if that’s the case, then you may be able to recover in time.
Another approach, however, would be to conduct the acid test for each of those periods. That is at the 30 and 60 day points, as well as the 90 day one.
And it’s here where you could come unstuck.
It may be comparatively easy to pay your own bills within 90 days and as a result, satisfy your creditors; but it’s just as likely that you will have bills to pay in the intervening period.
And when that happens, you can find yourself insolvent for 30 days or more.
Let me give you an example to show you what I mean. I’ll use small numbers to make it easier to follow.
Let’s imagine that you have $1000 cash on hand and that you have $4000 in outstanding invoices. That makes your total liquid assets $5000.
And let’s also say that your invoices are supposed to be paid within 60 days. So theoretically, you will have $5000 in hand in about two months.
What are your expenses during that time? How much do they add up to be? Is it more or less than $5000? What would happen if your largest customer decided to postpone payment for another month? Would you be temporarily insolvent?
It’s in such circumstances that factoring those invoices can be helpful.
When you fail the acid test, you don’t want to a loan. You probably don’t want to tell your bank that you’re temporarily insolvent, and you’d like their help. J
And even if you could get a loan, it would be the last thing you would want because the added debt would increase your liabilities, making the ratio worse; not better.
So by factoring some of your invoices at least, you could prevent the unthinkable from happening to you.