Once in a while, a client gets interested in financial ratios. Dry stuff I suppose, but these indicators are given weight by Banks and other institutions. So what is a ratio? Here you go:
the quantitative relation between two amounts showing the number of times one value contains or is contained within the other.
"the ratio of men's jobs to women's is 8 to 1"
So if it's helpful to a Loan Officer to have a few ratios for a business being considered so be it. The ratios commonly used are the Current Ratio ( acid test ratio), Debt Ratio and a few others.
The Current Ratio is also called the acid test and/or the Quick Ratio. It tells us whether a business has enough liquid assets to cover its current expense. The formula is
CURRENT ASSETS (comprised of Cash and Cash Equivalents + Current ARs + Short Term Investments
Current Liabilities
So if your business had $120,000 in current assets and $60,000 in Current Liabilities the ratio is 2.0. Is this good? It generally would be fine but every industry has its characteristics and it might be low for some businesses. It simply means that this business has $2 for every $1 owed in the short term.
The Debt Ratio is also a simple calculation of Total Debt/Total Assets. Here is what Investodpedia says about its use:
What Does the Debt Ratio Tell You?
The higher the debt ratio, the more leveraged a company is, implying greater financial risk. At the same time, leverage is an important tool that companies use to grow, and many businesses find sustainable uses for debt.
So a business with $500,000 of Assets and $300,000 of Debt has a Debt Ratio of 0.6. Again, this could be good or for some industries could be too high and therefor bad. Generally, a business must be able to service its debt making the required payments for interest and principal plus pay its other liabilities to remain open. The higher the debt ratio, the less likely that becomes and more risky to lenders.
Ratios help management too so I at least recommend using the Current Ratio and Debt Ratio to gain better insight into your business's financial health. When you hear of companies having Billions in cash, that's a current asset but they still may have debt too. It's the ratio that suggests it's too much or possibly too little debt. Putting assets to use to generate more revenue is a dance management dances so there is judgement in making such decisions. Having a good cash reserve is a safety net for unexpected events or a kiddy for opportune purchases etc., so using debt can be an important factor in the long term safety of a business while leaving ready cash available.
Other simple calculations can be useful like Liquidation Value for example. it attempts to calculate an amount that could be realized fast upon sale of tangible assets. It demonstrates what a Bank might get in event of a business going belly up. It is not a sale of a going concern and often is used in bankruptcies. A higher Liquidation Value tells a Bank they're loaned money is safer because it can bring a better price if the worst happened. Same holds true when ARs are used as collateral. Lenders want to know that the ARs are indeed collectible and could be turned into cash in a liquidation.
If you have any questions or concerns about Ratios or other Financial Reporting call or email. Also, I can often help a business look its best when seeking loans.
Good Luck.
Donn Marier
DM-Your Own CFO