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To contact your local Ledgers Representative Please call 1.888.470.0772 - 2 - Financial Ratios and Bank Financing
Ratio Analysis involves measuring the proportional relationship between two single amounts. These may be selected from one financial statement, such as the statement of income, or from two statements such as the statements of income and financial position. The amounts may represent the balances of two different accounts, the balance of one account and a classification total, such as total assets, or two classification totals.
In evaluating the significance of ratios, consideration must be given to the purposes for which the ratios are to be used. Investors, creditors and managers encounter different kinds of problems and decisions. Therefore, different ratios are often meaningful to each group of users within the specific decisions that are to be made.
The following five categories of financial analysis ratios are the most commonly used:
Liquidity Ratios
These indicate the ability of the company to meet its short-term financial obligations when they fall due.
Leverage-Capital-Structure Ratios
These indicate the ability of a company to fulfill its long-term commitments to debt holders.
Profitability Ratios
These indicate the level of profit generated by the company.
Turnover Ratios
These indicate the efficiency of the company in utilizing its assets.
Capital Market Ratios
These indicate a companys ability to win the confidence of the stock market.
To contact your local Ledgers Representative Please call 1.888.470.0772 - 3 - The following table illustrates the various ratio types, formula, classification and significance.
Ratio Formula Classification Significance
Earnings per Share (common shares) (Net Income Preferred Dividends) Number of Common Shares Outstanding
Capital-Market Ratio Tends to have an effect on the market price per share, as reflected in the price- earnings ratio.
Fully diluted earnings per share (Net Income Preferred dividends) (The average number of common shares outstanding +Average number of common shares issued on the assumed conversion of convertible securities)
Capital-Market Ratio Shows the potential effect on earnings per share of converting convertible securities into common shares.
Price-Earnings Ratio Market Price per share Earnings per share
Capital-Market Ratio An index of whether a share is relatively cheap or relatively expensive and a measure of investor confidence.
Dividend Payout Ratio Dividends per share earnings per share
Capital-Market Ratio An index showing whether a company pays out most of its earnings in dividends or reinvests the earnings internally.
Dividend Yield Ratio Dividends per share Market Price per share
Capital-Market Ratio Shows the dividend return being provided by a share, which can be compared to the return being provided by other shares.
Return on Total Assets Net Income +[Interest Expense x (1-tax rate)] Average total assets
Profitability Ratio Measure of how well assets have been employed by management.
Return on Common Shareholders Equity (Net Income Preferred Dividends) Average common shareholders equity.
Profitability Ratio When compared to the return on total assets, measures the extent to which financial leverage is being employed for or against common shareholders.
Book Value Per Share Common shareholders equity number of common shares outstanding
Capital-Market Ratio Measures the amount that would be distributed to holders of each common share if all assets were sold at their balance sheet carrying amounts and if all creditors were paid off.
To contact your local Ledgers Representative Please call 1.888.470.0772 - 4 -
Ratio Formula Classification Significance
Working Capital Current Assets Current Liabilities
Liquidity Ratio Represents current assets financed from long-term capital sources that do not require near-term repayment
Current Ratio Current Assets Current Liabilities Liquidity Ratio Test of short term debt- paying ability
Acid-Test (Quick) Ratio (Cash +Marketable Securities +Current Receivables) Current Liabilities
Liquidity Ratio Test of short-term debt paying ability without having to rely on inventory.
Accounts Recei vable Turnover
Sales on account Average accounts receivable balance
Turnover Ratio Measure of how many times a companys accounts receivable have been turned into cash during the year
Average Collection Period (age of recei vables)
365 days Accounts Receivable turnover
Turnover Ratio Measure of the average number of days taken to collect an accounts receivable.
Inventory Turnover Cost of goods sold Average inventory balance
Turnover Ratio Measure of how many times a companys inventory has been sold during the year.
Average Sales Period (turnover in days) 365 days Inventory turnover
Turnover Ratio Measure of the average number of days taken to sell the inventory one time
Times Interest Earned Earnings before interest expense and income taxes interest expense
Profitability Ratio Measure of the likelihood that creditors will continue to receive their interest payments.
Debt to Equity Ratio
Total Liabilities Shareholders Equity
Leverage-Capital-Structure Ratio Measure of the amount of assets being provided by creditors for each dollar of assets being provided by the shareholders.
Net Profit Margin Net Income Sales Profitability Ratio Measure of the companys profitability.
To contact your local Ledgers Representative Please call 1.888.470.0772 - 5 - Ratios used by banks when determining credit worthiness
When a Small Business applies for credit with a bank, the bank will look at the following items:
Working Capital should be in line with the operating credit being requested.
Current Ratio a minimum of 1:1
Debt to Equity no higher than 2:1
Debt Service Coverage minimum of 125% coverage, calculated as Earnings before: Interest, Taxes, Depreciation and Amortization debt payments to be made.
Accounts Receivable Consistent Turnover, with no negative trends and generally no more than 10% of receivables greater than 90 days, or in any one receivable making up more than 10% of the total amount of receivables.
Inventory Consistent turnover, with no negative trends. Inventory is something that the banks are reluctant to finance and do not take inventory values into great consideration when offering financing or credit facilities.
One of the most important pieces of applying for credit in a small business is the personal position of the principal owner of the business. If the owner is in good credit standing, relatively secure and has a good past credit history, this may be enough for the bank to offer credit facilities. If the principle of the business is not in good standing, they will take a closer look at the financial statements, ratios, and positioning of the business.
Although this is a generalization of the requirements of lending institutions, using these recommendations as guidelines can dramatically improve your client relations by adding value to your services.
Using the Magic Carpets Inc. sample financial statements, we can calculate the ratios as follows in the chart below:
To contact your local Ledgers Representative Please call 1.888.470.0772 - 6 -
Ratio Formula Values Result Comment
Working Capital Current Assets Current Liabilities $62,036 $67,446 ($5,410) Poor, cash will not satisfy obligations
Current Ratio Current Assets Current Liabilities $62,036 $67,446 0.92 Poor, cash cannot satisfy obligations
Acid-Test (Quick) Ratio (Cash +Marketable Securities +Current Receivables) Current Liabilities
($1,321 +$30,584) $67,446
0.47 Poor, cash cannot satisfy obligations
Accounts Recei vable Turnover Sales on account Average accounts receivable balance
$337,228 $30,584
11.02 Very good, credit sales are well controlled
Average Collection Period (age of recei vables) 365 days Accounts Receivable turnover
365 11.02
33.12 Very good, receivables rarely extend beyond terms
Inventory Turnover Cost of goods sold Average inventory balance $135,245 $26,914 5.02 Good, Inventory is turned over frequently reducing risk of obsolescence
Average Sales Period (turnover in days) 365 days Inventory turnover 365 5.02 72.70 Fair, should consider carrying less inventory
Times Interest Earned Earnings before interest expense and income taxes interest expense
($18,571+2,679+3,532) $6,211
3.99 Fair, Industry average is considerably higher
Debt to Equity Ratio Total Long Term Debt Shareholders Equity $86,620 $23,647 3.66 Poor, however, large portion of debt is due to shareholders. Reclassify shareholder loans changes ratio to: 1.25 which is good
Net Profit Margin Net Income Sales $15,589 $337,228 4.6% Fair, Industry average is considerable higher
Debt Service Coverage EBITDA Debt payments obligation $38,244 $18,216 2.09 Good, business is earning considerably more than is required to service the debt payments.
To contact your local Ledgers Representative Please call 1.888.470.0772 - 7 - Summation of this example:
The Current Ratio (0.92) is close to the required minimum of 1:1
The Debt to Equity ratio, when restated to exclude shareholder loans is within acceptable ranges (1.25)
Debt Service Coverage is within acceptable ranges (minimum 1.25)
Accounts Receivable Turnover is very good (11.02)
Inventory Turnover is Good (5.02)
Therefore, assuming the credit history and personal financial status of the principles is satisfactory, the bank would most likely approve this client for a small business loan to finance equipment purchases, or other capital assets. The bank would also likely be inclined to extend a small ($10,000 - $20,000) line of credit to the business in order to provide working capital.
Restrictions:
The bank, in its application of credit policies would likely place a restriction on the repayment of shareholder loans as well as a freeze in the salaries of the managing partners.
The bank would require monthly financial statements of the business to maintain the approval of the line of credit.
The bank would monitor the inventory turnover as well as the status of the accounts receivable each month.
The bank would require personal guarantees of the managing partner(s) of the business as well as a general security agreement with the assets of the business being pledged as collateral.
By utilizing these simple ratio analyses, you can provide your clients with valuable insight into the credit worthiness of the business as well as advising them of ways to bring the ratios in line with what may be required by the banks when applying for financing.
Note: We thank TDCanada Trust for their assistance in the preparation of this information
To contact your local Ledgers Representative Please call 1.888.470.0772 - 8 - Ratio Analysis Advice for Clients:
Accounts Receivable Turnover and Inventory Turnover are probably the most easily changed values, and, by increasing the turnovers, all other ratios can dramatically change.
For Example, assume a business has the following:
Current Assets: 59,000 Cash is 1,000 Accounts Receivable: 33,000 with 25% greater than 90 days Inventory is 25,000 Current Liabilities: 75,000 Gross Margin on Sales of 40%
Therefore the following exists:
The working capital of the business is ($16,000) - very poor The current ratio of the business is 0.78 - poor The quick ratio of the business is 0.45 - poor
A bank would be reluctant to extend credit to this business in the above situation, however, if the business reduced its inventory by 30% through sales and increased the collections on accounts receivable, bringing the over 90 days to 5%, and assuming all cash generated is used to reduce current liabilities, the ratios would become:
Current Assets: 44,900 Cash: 1,000 Accounts Receivable: 26,400 Inventory: 17,500 Current Liabilities: 50,900
Now, the following exists:
Working capital becomes: (6,000) -fair Current ratio becomes: 0.88 -fair Quick ratio becomes: 0.53 -poor
A bank would be more inclined to provide financing at this point, if all other items remained equal. Therefore, by advising your client to keep inventory levels as low as possible and by focusing their efforts on accounts receivable, they can put the business in a much more amendable financial position.
Other effects: In this example, the overhead would not theoretically change, therefore the net earnings should have increased due to the sales of goods from inventory.
Accounts receivable turnover will have increased Average age of receivables will have decreased Inventory turnover ratio will have increased Average age of inventory will have decreased
These trends in ratio changes would illustrate to the bank that the management of the company is making changes to increase the performance of the business and to make the future operation of the business more attractive to lending.
To contact your local Ledgers Representative Please call 1.888.470.0772 - 9 - Other suggestions to enhance the ratios:
If, in the above example, the principal of the business earns $4,000 per month in wages, and they were to forego payment of wages for 1 month, assuming all other items remained equal, the following would exist:
Current Assets: 44,900 Cash: 1,000 Accounts Receivable: 26,400 Inventory: 17,500 Current Liabilities: 46,900
Now, the following exists:
Working capital becomes: (2,000) - fair /good Current ratio becomes: 0.95 -good Quick ratio becomes: 0.58 -poor Net earnings will have increased -good
Consider converting short-term debt to long-term debt (debt consolidation) If the business has a number of credit cards, lines of credit or other similar current obligations, provide a ratio comparative analysis by converting the consolidated values to a term loan and review the effect on ratios and cash flow.
If, in the above examples, the company had $10,000 included in accounts payable that could be converted to a 36-month term loan, the Current Ratio would become 1.21. The interest on the term loan would also be considerably less than the interest on the credit cards, therefore increasing cash and net income.
Sale / Lease Back of Fixed Assets: There are businesses / lenders that specialize in this area. If a client has a large amount tied up in fixed assets, they could evaluate a sale/lease-back option. This will immediately increase cash and working capital, strengthening the Current ratio and the quick ratio. Depending on the type of lease (operating vs. capital) the net earnings of the business could be affected, a detailed analysis of the net effect of this option must be completed before recommending to the client.
Employees and Payroll: Payroll is one of the largest expenses of virtually all businesses. A business owner should review frequently the staffing of the business. By reducing the payroll costs, the savings if applied to accounts payable will strengthen working capital, the current ratio, the quick ratio and the net earnings of the business. Can some of the employees be converted to part-time? Could certain positions be better served by contract employees or outsourcing? Could benefit costs be reduced without harming employee relations?
Reduction in pre-paid expenses: Does the client have prepaid insurance, taxes, utilities or other items? Converting these expenses to a monthly payment plan, would increase cash flow, and allow for the reduction in current liabilities. Therefore strengthening the ratios.
Essentially, any cost savings the business can realize will strengthen net income, and, all other items remaining equal will improve the ratios that lending institutions look at.