Smart ways to ratio-nalize your business planning
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Typically, the more your business grows, the more complex your finances become. Even the most diligent owner or CEO may find it increasingly difficult to get a quick measure of their company’s health. That’s when it pays to go back to your Accounting 101 class and renew your acquaintance with some handy benchmarks.
As you were learning about income statements and balance sheets, your instructor probably shared some simple ratios that offer a surprising amount of insight into the condition of your company’s finances. While simple ratios don’t provide the same degree of information as in-depth reviews, they provide an easy way to glance at how well you’re doing. Even more important, they can deliver an early warning of potential trouble.
That’s why those ratios and others like them are widely used by lenders as we determine your creditworthiness and while we service your loan. Again, they may not provide all the information we need to make key decisions, but they send a signal that something may warrant an in-depth look. Your CPA can help you determine the right benchmarks for the nature of your company and industry.
I realize it’s been a long time since you sat in that Accounting class (and I’m willing to wager it wasn’t your most enjoyable or memorable academic undertaking), so I’ll reintroduce you to some of the most valuable ratios and the insight they offer. Reviewing them at least monthly can call attention to situations long before they become pressing problems.
Quick Ratio. Let’s start with the most simple ratio. It’s as easy as dividing your liquid assets — primarily your cash and receivables — by your current liabilities. This ratio spotlights your company’s ability to meet its near-term obligations with your most liquid assets. If you determine that your quick ratio is 1.75, it means you have $1.75 in liquid assets to pay off every $1.00 of current liabilities. But if your quick ratio falls below 1, it’s a sign your liabilities are coming due before you can afford to pay them, and time to take a deeper dive to understand why.
Working Capital Ratio. This ratio is good for measuring your ability to meet your company’s operating obligations. You compute it by dividing current assets by current liabilities. Again, a ratio below 1 is a sign of trouble, although a ratio that’s too high suggests you’re not using your assets as efficiently as you should. The working capital ratio is particularly important when you’re planning an investment or other large project, because such projects will at least temporarily reduce working capital.
Debt Service Coverage Ratio. The DSCR ratio is computed by dividing net operating income by current debt obligations. If the ratio falls below 1, it indicates the company probably can’t make its debt payments without accessing additional cash (or taking out more debt). However, even a positive result may signal problems. For example, if your company’s DSCR is just 1.2, an unexpected decline in cash flow could put you in danger of being unable to make debt payments.
Debt to Equity Ratio. Similar to the DSCR, the debt to equity ratio provides a snapshot of a company’s financial leverage. It involves dividing total liability by the total equity of shareholders or partners. A high debt to equity ratio suggests an increased level of risk because the company’s debt is unusually large. It may also suggest the shareholders are less willing to put their own investments at risk, making the company less attractive to lenders.
Earnings trends. While studying changes in your company’s earnings doesn’t really qualify as a ratio, it can be just as instructive. Month-over-month earnings can be volatile, especially if your business is seasonal, but examining longer-range trends can provide an early warning of problems. One simple approach is to set up a spreadsheet with a moving average, such as the average of the last 12 months of earnings. Using a moving average lets you look past short-term volatility so you can focus on longer-term performance.
Covenants. Finally, if your business has taken any loans, it’s always important to pay close attention to any covenants associated with that debt. You need to have a clear understand of how those covenants are calculated, and if you haven’t already shared those details with your CPA, do so right away. That little extra bit of work will minimize the possibility you’ll get an unpleasant surprise call from your lender letting you know your loan no longer complies with the terms you agreed to meet.
Karen Gregerson is President & CEO of The Farmers Bank, a locally owned and operating bank with 11 banking offices in Central Indiana.