Smart Ways to Streamline Your Business Planning – Inside INdiana Business
Generally, the larger your business grows, the more complex your finances become. Even the most diligent owner or CEO can find it increasingly difficult to get a quick measure of the health of their business. That’s when it’s worth returning to your Accounting 101 course and refreshing your knowledge with some handy pointers.
While you were learning about income statements and balance sheets, your instructor probably shared some simple ratios that offer surprising insight into the state of your business’s finances. Although simple ratios don’t provide the same degree of information as in-depth reviews, they do provide an easy way to see how well you’re doing. More importantly, they can provide an early warning of potential issues.
That’s why these and similar ratios are widely used by lenders when we determine your creditworthiness and service your loan. Again, they may not provide all the information we need to make key decisions, but they do send a signal that something may warrant further investigation. Your CPA can help you determine the right credentials based on the nature of your business and your industry.
I realize it’s been a while since you’ve attended that accounting course (and I’m willing to bet it wasn’t your most enjoyable or memorable academic endeavor), so I’m going to introduce again some of the most valuable ratios and insights they offer. Reviewing them at least once a month can draw attention to situations long before they become pressing issues.
Quick report. Let’s start with the simplest ratio. It’s as simple as dividing your cash – primarily your cash and receivables – by your short-term debt. This ratio highlights your company’s ability to meet its short-term obligations with your most liquid assets. If you determine that your quick ratio is 1.75, that means you have $1.75 of liquid assets to pay off every $1.00 of current liabilities. But if your general liquidity ratio falls below 1, it’s a sign that your debts are coming due before you can afford to pay them, and it’s time to dive deeper to understand why.
Working capital ratio. This ratio measures your ability to meet your business operating obligations. You calculate it by dividing current assets by current liabilities. Again, a ratio below 1 is a sign of trouble, although too high a ratio suggests you are not using your assets as efficiently as you should. The working capital ratio is particularly important when planning an investment or other large project, as such projects will at least temporarily reduce working capital.
Debt service coverage ratio. DSCR is calculated by dividing net operating income by outstanding debt. If the ratio falls below 1, it indicates that the company probably cannot service its debt without accessing additional cash (or incurring more debt). However, even a positive result can signal problems. For example, if your company’s DSCR is only 1.2, an unexpected drop in cash flow could put you at risk of not being able to repay your debts.
Rate of endettement. Similar to the DSCR, the debt-to-equity ratio provides insight into a company’s financial leverage. This is to divide the total liability by the total shareholders’ or partners’ equity. A high debt ratio suggests an increased level of risk because the company’s debt is exceptionally high. It may also suggest that shareholders are less willing to put their own investments at risk, making the company less attractive to lenders.
Earnings trends. Even though studying the evolution of your company’s profits is not really considered a ratio, it can be just as instructive. Month-to-month revenue can be volatile, especially if your business is seasonal, but looking at longer-term trends can provide early warning of trouble. A simple approach is to set up a spreadsheet with a moving average, such as the average revenue for the last 12 months. Using a moving average allows you to look beyond short-term volatility so you can focus on longer-term performance.
Pacts. Finally, if your business has borrowed money, it is always important to pay close attention to the covenants associated with that debt. You need to have a clear understanding of how these engagements are calculated, and if you haven’t already shared these details with your CPA, do so right away. This little extra work will minimize the possibility of you receiving an unpleasant surprise call from your lender telling you that your loan no longer meets the terms you agreed to.
Karen Gregerson is President and CEO of The Farmers Bank, a locally owned and operated bank with 11 banking offices in central Indiana.