This is the fourth article in a series about financing your business. We previously reviewed potential financing sources, the lender’s perspective and events that cause the need for financing. In this article we will look at ratio analysis and how it can help you get valuable information about your business so you can make proper and timely decisions.
The value of ratio analysis is that it enables you to compare your financial results from one period to the next on an “apples to apples” basis instead of on an “apples and oranges” basis. For example, let’s say that you made a $10,000 profit in one period and in the next period you made a profit of $25,000. Based only on the dollars you earned, you would think that your bottom line was improving, but what if I told you that your profit margin in the first period was 10% and in the second period you had a 5% profit margin? The $25,000 profit does not seem to be as much of an improvement, does it?
In this example, comparing dollars from one period to the next is the “apples and oranges” approach; comparing profit margins is the “apples to apples” method.
Another benefit of ratio analysis that it indicates what you must do to solve a problem you may uncover. For example, assume that your accounts receivable are $10,000 in March and $15,000 in April. At first glance, it would seem that you are doing well, because if your receivables increased, then your sales must have increased as well.
However, your accounts receivable could have gone up because your sales remained at normal levels but your existing customers were taking longer to pay. This would tell you that you need to step up your collection of customer accounts. It’s also likely that your credit policy needs to be reviewed to determine if (a) you are following the policy and (b) the policy is too lax.
Here’s a quick list of ratios you can use to gauge your financial health:
- Current Ratio – Compares current assets to current liabilities to give an indication of your firm’s liquidity. It answers the question: If I convert all of my current assets to cash and pay off my current liabilities, how much cash do I have left over?
- Quick Ratio – Same as the current ratio, but excluding inventory from the current assets. Considered by some to be a truer test of liquidity, this ratio answers the question: If I cannot liquidate my inventory, would I be able to pay off all of my current liabilities just using the cash on hand and monies I collect from receivables?
A note about the current and quick ratios. You generally want to have a ratio of 1:1 or higher. In other words, you want your current assets to at least be equal to or greater than your current liabilities. If you are consistently below 1:1 it could mean that you are not collecting receivables on a timely basis, that your inventory is not turning over fast enough, or that you are taking too long to pay your vendors. It could also mean that you have the wrong debt structure and that you are using short term debt to finance long term needs.
- Turnover Ratios – These are used to determine how long it actually takes to collect receivables, sell inventory, and pay vendors. Turnover ratios are used to determine the liquidity of your firm.
- Debt / Worth – This ratio compares your total debt to your company’s equity. In other words, it answers this question: How much of your assets are paid for with debt, and how much are paid with equity? The answer determines your ability to borrow more money, and also has an impact on your cash flow: the more debt you have, the more you have to use profit to pay debt and the less money you have to reinvest in your business. This ratio is a leverage ratio. In other words, how leveraged are you, how much of your business is financed with debt as opposed to funds generated by ongoing operations?
- Margins – These are profitability ratios, used to determine not only how profitable you are, but also your ability to earn a consistent level of profit over a period of time. Common margins used are gross margin (profitability after paying the cost of materials, inventory), operating margin (profitability after paying all ongoing costs incurred to run the business), and net margin (profitability after all expenses have been paid – the “bottom line”).
- Times Interest Earned – This compares profit to interest expense to determine your ability to service debt.
In the next article, we will look at the flow of funds in your business and working capital.
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