When you go to a bank or supplier to gain credit, you have to provide some kind of financial information about your business. Typically they require you to complete a credit application and current financial documents. While the income or profit/loss statement is important to shows sales volume, what is really more important in determining credit is your balance sheet.
On the balance sheet are two important categories that are used by financial institutions to grant credit. The first category, under Assets, is Current Assets and the second, under Liabilities, is Current Liabilities. Current Assets are sometimes called “liquid” assets and include those assets that will turn to cash within one year. Current Assets typically include Cash in the bank, Accounts Receivables, and Inventory. Current Liabilities are those debts that are due within one year and include Notes Payables and Accounts Payables.
If you divide your Total Current Assets by your Total Current Liabilities you get what is commonly called the Current Ratio. If the ratio for example is 1.20, then you have $1.20 to pay $1.00 worth of bills. If the value is $0.80, then you have 80 cents to pay $1.00 worth of bills. As contractors, we want a Current Ratio between 1.5 and 3.0. This gives us plenty of money to cover our current obligations and grow the business. If the Current Ratio is less than 1.0, you cannot keep up with your current debt, so why would someone grant you credit??? If the Current Ratio is too high, you may have too money tied up in Inventory, too much cash in the bank sitting idle, or too much accounts receivables indicating poor collections. Keep your current ratio between 1.5-3.0 and you should be fine.
If you divide your Cash + Accounts Receivables by your Total Current Liabilities, you get what is commonly called the Acid Test or Quick Ratio. This tells a financial institution not only if you can pay your current bills, but also how quickly they can be paid. You want a Quick Ratio between 1.0-2.0 to show the credit granting institution that you do not have a lot of your monies tied up in Inventory that is not easy to sell.
Check both these ratios monthly because you never know when you will need to borrow money. Good luck with your credit.