Part 1 of 3
Financial ratios are often not clearly understood by the small business entrepreneur or not properly utilized to provide a financial profile of the company. Financial Ratios, properly used, reveal key strengths and weaknesses within the structure of the company that will enable or prohibit the achievement of long-term strategic goals.
There are no concrete “right” or “wrong” ratios for any business. Each must be considered only as a basis for comparing your company’s situation to what is happening with other companies in the same business segment and your company’s historical data.
In the changing environment brought about by pressure to outsource some of the production, it becomes even more important to use the ratios as indicators of financial trends and the company’s viability.
Financial Ratios Used By Lenders To Evaluate A Company
Business Financial Profile
A financial profile is a comparison of the ratios calculated for a specific company with that of the industry averages for the particular industry to which the company belongs. The industry is identified by a SIC (Standard Industry Classification) number that is the closest to your company’s type of services or/and products provided.
This financial profile provides a means of relating the financial strength and performance of the company to the industry as a whole. It provides management with a frame of reference. Comparisons of the individual ratios of the company with industry averages highlight any underlying problems that the company may have. It focuses management’s attention on areas that require further examination and analysis.
Financial ratios are derived from the company’s financial statements – the Income Statement and the Balance Sheet. The key company ratios that offer critical insight for small business are listed and defined as follows:
Liquidity Ratios
Liquidity is a measure of the quality and adequacy of current assets to meet current obligations as they become due.
The Current Ratio: Total Current Assets ÷ Total Current Liabilities
This ratio measures the ability of a firm to pay obligations that will come due within one year or during the operating cycle, whichever is longer, using its current assets. Current assets normally include cash, marketable securities, accounts receivable, and inventories.
Current liabilities consist of accounts payable, short-term notes payable, current maturity of long-term debt, accrued income taxes, and other accrued expenses (principally wages).
It shows this as the number of times a firm’s current assets can pay off its current liabilities. This ratio considers the shrinkage of current assets. A generally accepted principle is that a 2:1 ratio implies a healthy relationship. This means that you should have twice the Current Assets than you have Current liabilities. Low or declining ratios here may indicate an insufficient margin of safety for meeting obligations.
On the other hand, a high ratio may indicate the presence of a lot of unproductive cash or inventory or outstanding Accounts Receivable. Although a ratio of 2 to 1 has often been singled out as desirable, this rule of thumb is not necessarily valid.
Ratios will vary in different industries. In fact, some companies may operate quite satisfactorily with ratios of only slightly greater than 1 to 1.
Generally, the higher the current ratio, the greater the “cushion” between current obligations and the firm’s ability to pay them. The stronger (higher) ratio reflects a numerical superiority of current assets over current liabilities.
However, the composition and quality of current assets is a critical factor in the analysis of the individual firm’s liquidity. This ratio is presumed to indicate the ability of the concern to meet its current obligations.
Financial Ratios Used By Lenders To Evaluate A Company
Quick Ratio: Cash & Equivalents + Trade Receivables ÷ Total Current Liabilities This ratio is also known as the Acid Test Ratio. It is a refinement of the current ratio and only considers the firm’s most liquid assets.
Typically this includes cash, Other Investments, and Accounts Receivable. It takes inventory and net investment in leases out of the picture.
The ratio expresses the degree a company’s current liabilities are covered by the most liquid current assets. Generally, any value of less than 1 to 1 implies a reciprocal dependence on other current assets to liquidate the long-term debt.
This is a more conservative measure of the ability to cover current obligations because inventories, which take some time to convert to cash, are not included.
In part two of this three-part series we discuss this topic more on Business Management Ratios For Small Businesses
**If you enjoyed this article you may also like our book,
“DIY Business System”, now available on Amazon.
http://www.amazon.com/dp/1549881752