Ever wonder how banks determine whether your business is a good credit risk for them? And by that, I really mean, whether they will loan your business money, and what interest rates will you be offered? As a refresher, interest rates are often a reflection of your credit worthiness – banks want to lend credit worthy people money, so they offer it at lower interest rates, and higher interest rates are offered if you may have difficulty paying it back. Think of a home equity loan versus a store credit card. Banks loan money to individuals by primarily looking at their credit scores, but for businesses it is a little different and includes analyzing some ratios. You should not what these ratios are as you cannot play the game if you don’t know the rules.
Ratios provide key insight to lenders about the financial health of a business and its ability to repay loans. You may not be an expert in this field, but understanding some key financial ratios will not only help you manage your business, but be aware of what the bank or other lenders tend to look at either before or after they lend you money.
While there are many ratios, we have singled out the seven most important ones that lenders tend to review before deciding the creditworthiness of a business.
The current ratio is used as a liquidity ratio, and it is a reflection of a company’s financial strength. In order to calculate it, all current assets are divided by all current liabilities according to the following formula:
Current ratio = Total current assets/ Total current liabilities
Using this calculation, you can determine if you have enough assets to cover your liabilities. For instance, if an organization has $600,000 in assets and $300,000 in liabilities, its current ratio is two (current assets cover your current liabilities 2x).
A current ratio of 1.0 or greater is usually considered acceptable for most businesses, but obviously the larger the number above 1.0 the better. This information helps creditors determine whether a company can repay its debt over the next year. However, it is essential to consider the nature of the business and the types of assets and liabilities in determining the adequacy of the current ratio.
As a means of improving current ratios, a business should increase its current assets or decrease liabilities. This can be accomplished through a series of steps, including paying down debts, acquiring a long-term loan, or selling a fixed asset.
The quick ratio is often referred to as the acid test ratio because it only considers a company’s most liquid assets versus its current liabilities. Furthermore, it determines whether an organization can meet its obligations even in adverse circumstances. This ratio is calculated by subtracting the inventory from current assets and dividing this total by current liabilities.
Quick ratio = (Current assets – Inventory) / Current liabilities
Current assets can be converted to cash within a short period, typically 90 days. They include marketable securities, accounts receivable, cash, and cash equivalents. Having enough quick assets to cover a company’s total current liabilities increases its chances of being able to pay off its obligations without selling any capital or long-term assets.
However, the conversion of inventory to full cash value takes time. If a significant amount of current assets serves as inventory, banks or investors will probably compare your business’ quick ratio to the current ratio. The higher the former, the better. But the minimum number should at least be one. If your quick ratio is less than 1.0, your debts exceed your assets and is an indication of potential liquidity problems.
EBITDA is an acronym for Earnings Before Interest, Taxes, Depreciation, and Amortization. It is used to measure a company’s overall financial performance, which makes it the key figure investors and banks consider. EBITDA estimates your company’s net profit before depreciation, taxes, and interest are accounted for. The EBITDA margin is then determined by dividing this number by net sales.
EBITDA margin = EBITDA / Total revenue
The EBITDA margin represents a business’s annual cash profit. Investors and lenders prefer figures of 10% or higher. For instance, a company has an EBITDA of $600,000 and total revenue of $6,000,000. Once you do the math, the result is a 10% EBITDA margin.
This ratio highlights the company’s level of debt against the amount invested by shareholders. How much of the business is owned outright versus how much is being funded by debt. It shows a lender the answer to 3 important questions:
Debt-to-equity ratio = Total liabilities / Shareholder’s equity
Debt to equity ratios vary by industry, and with finance theory, you can actually calculate the optimum debt to equity ratio to maximize your ROI (return on Investment), but a good rule of thumb is somewhere between 2:1 and 2.5:1 debt to equity is acceptable for lenders. A ratio higher than that would suggest that your business is over leveraged.
The debt service coverage ratio (DSCR) is a vital financial factor in many credit institutions. By comparing net income with total debt service obligations, the DSCR examines a company’s ability to service its current debts using its operating cash flow. When analyzing a company, this credit metric is rarely measured in isolation — liquidity and leverage are usually evaluated simultaneously.
Although there are different ways to calculate the DSCR, most use EBITDA as a proxy for cash flow.
Debt Service Coverage Ratio = (EBITDA – Cash taxes) / (Interest + Principal)
If a DSCR is less than one, it shows the business cannot meet its debt obligation with operating profit alone. It also means that it currently makes more interest and principal payments than it earns in operating profits. A good DSCR value is 1.25 or more because the higher ratios indicate that the borrower is more likely to be able to make loan payments without causing the business any financial stress.
Generally, lenders prefer sectors that are not cyclical and with low capital expenditures, such as the service industry. However, they adjust the DSCR formula based on their risk appetite and the nature of the loan application.
Days sales outstanding, or DSO, measures the average number of days a business takes to receive a payment for a specific sale. It is usually calculated monthly but can also be done quarterly or annually. Simply divide the average accounts receivable (outstanding balance of accounts receivable at a point of time) over a certain period by the total amount of credit sales during the same period. Then, multiply the result by the number of days during the period you want to measure.
DSO = (Accounts receivable / Total credit sales) x Number of days
When a company’s DSO number is high, it indicates that payments are being delayed, which can often cause cash flow issues. Low DSOs (under 45 days) suggest that the company receives payments quickly. After all, the faster the business collects its outstanding accounts receivables, the better because those funds can be reinvested. It’s worth noting that the DSO formula doesn’t account for cash sales but only credit sales.
Additionally, daily sales outstanding can provide other valuable insights, such as the efficiency of the company’s collections department and customer satisfaction levels, and identify the non-creditworthy customers.
DSO is also a vital instrument for measuring liquidity, a company’s collection efforts, and sales efforts. Whenever sales decrease in isolation, DSO will increase, indicating potential cash flow problems in the future. However, if sales decline proportionately to receivables, DSO will not increase.
This type of ratio is useful for businesses that carry inventory. It determines the number of times inventory was converted to sales during a specified period. Using this method, you can estimate if a business has too much inventory in relation to its sales level. It is also known as cost-of-sales to inventory ratio, merchandise turnover, stock turns, or stock turnover. You can calculate it monthly, quarterly, or annually using this formula:
Inventory ratio = Cost of goods sold / Average value of inventory
As long as your cost of sales to inventory ratio is high, it indicates that you are turning your goods over frequently and storing a small amount of unused inventory. After all, you will lose money if the merchandise sits on your shelves for a long time. For instance, food-related businesses will have a higher inventory turnover ratio than businesses with more expensive, non-perishable products.
Using this ratio can help determine if you are wasting money or resources on slow-moving or non-saleable items. Additionally, you will be able to identify areas for improvement in your inventory management and buying practices.
Lending institutions will often use this ratio as collateral when making loans based on inventory. Banks will be less likely to lend you money if your product is hard to sell. When considering additional financings for your business, such as a small business loan or investment from an outside investor, you need to evaluate your inventory turnover ratio and improve it if necessary.
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This blog is not meant to provide specific advice or opinions regarding the topic(s) discussed above. Should you have a question about your specific situation, please discuss it with your GBA advisor.
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