When a potential investor or creditor asks how risky your business is, how will your financials answer the question? The financial risks of your business can be assessed by answering these two questions:
- How liquid is our company?
- How are the company assets being financed?
HOW LIQUID IS YOUR COMPANY?
Your company is liquid when you have the ability to pay your debt obligations as they become due. The liquidity of your company can be assessed in two ways
- Compare the assets of your company that are relatively liquid in nature against the amount of your debts that are coming due in the near term
- Determine how quickly you can convert your liquid assets into cash.
Current assets (found on the Balance Sheet) include cash and other assets that can be converted to cash or to be used up within one year. It commonly includes temporary investments, accounts receivable, inventory and prepaid expenses.
Current liabilities (also found on the Balance Sheet), on the other hand, are obligations that are due to paid within one year of the balance sheet date. It commonly includes trade payables, salaries payable, tax payable and the current portion of a long-term debt.
Knowing the above two items, you can now assess the liquidity of your company using the following formula:
CURRENT RATIO = Current Assets / Current Liabilities
The current ratio shows a company's ability to meet its financial obligations. If your current liabilities is greater than your current assets (meaning your current ratio is below 1), it may indicate that your company is having problems in meeting your short-term obligations. On the other hand, a very high current ratio (more than 3) may also indicate problems in your working capital management – it can indicate you are not efficiently using the company's current assets to generate more revenue.
Acceptable current ratios vary from industry to industry but usually range from 1.5 to 3 for healthy businesses. When analyzing your financial statements, always remember to compare your results against other companies so you will also know how your company is faring against your competitors.
Amongst the components of Current Assets, Inventories is usually deemed as the least liquid – meaning it takes the longest time to convert inventory into cash because you need to go through the complete sales cycle. Because of this, an additional measure is commonly used in estimating the liquidity of company which is computed as:
QUICK RATIO = Current Assets – Inventories / Current Liabilities
The Quick Ratio is especially useful for companies whose inventories go through long operation cycle periods.
Accounts Receivable Turnover Ratio
As mentioned above, liquidity is the ability of a company to pay its debt obligations. When you sell goods or services on credit, you technically extend interest-free loans to your customers. You need set up solid credit policies for your company that will ensure the timely collection of accounts receivable.
One measure you can use to determine your company effectiveness in extending credit and collecting debts is the Accounts Receivable (AR) Turnover ratio.
AR TURNOVER = Net Credit Sales / Average Accounts Receivable
If all of your sales are on credit, the Net Credit Sales in the formula equals the total Sales amount on your Income Statement for the period less any sales discounts and sales returns. Otherwise, you also need to deduct any cash sales from the total Sales amount.
To get the average accounts receivable, add the accounts receivable as of the end of the prior period and as of the end of the current period and then divide by 2.
AR turnover measures the average number of times a business collects its receivables during a period. It is usually calculated at the end of the year but you will be able to see any trends promptly if you calculate it on a monthly or quarterly basis. Generally, a high value of AR turnover is favorable and a lower figure may indicate inefficiencies in collecting outstanding AR.
If for example you grant a 30-day credit term to your customers, you should be able to expect an AR turnover rate of around 12 in a year (since 30 days equals one month and there are 12 months in a year). Given the same assumptions, if your AR turnover is 5.7, it means that on average, you are able to collect your receivable in 2 months instead of 30 days (since 12 months in a year divided by 5.7 equals 2.10).
When you see that your AR turnover is increasing over time, it can indicate that your credit and collection process is also improving.
Inventory Turnover Ratio
Companies who sell goods need to set up efficient inventory management policies to ensure that they are able to maintain an optimal level of inventory to meet customer demands without overstocking which may pose risk of obsolescence and high inventory holding costs (warehousing).
The Inventory Turnover ratio can be used to measure a company inventory management efficiency.
INVENTORY TURNOVER = Cost Of Goods Sold / Average Inventory
Cost of Goods Sold is obtained from the Income Statement. Average Inventory is equal to Inventory at the end of prior period + Inventory at the end of current period / 2.
Similar to AR turnover, in general, a higher value of inventory turnover indicates good performance of the company while a lower value can indicate inefficiencies in managing inventory levels. Again, remember that inventory turnover varies from one industry to another. Companies which trade in perishable goods have very high inventory turnover compared to those dealing with durables. When assessing your AR turnover, you need to consider the full inventory cycle of your company from purchase orders to actual delivery to customers.
HOW ARE THE COMPANY'S ASSETS BEING FINANCED?
Before we continue, let us discuss LEVERAGE.
The Balance Sheet is called as such because it shows the accounting equation Assets = Liabilities + Equity. All of the company assets are financed either by funds borrowed from creditors or by the capital provided by the investors.
Why do companies borrow funds from creditors?
A company usually borrow funds to increase its leverage. This means that the business has more funds to finance operations without requiring the investors to increase their investments or equity.
For example, if a company was formed with the investors providing a total of $ 5 million as capital, the company has $ 5 million to finance its operations. If the company then borrowed an additional $ 20 million from creditors, it will now have a total of $ 25 million to use in business operations. A bigger fund will enable the company to generate more profits for the investors.
With the above debt financing leverage, the investors will gain four times more if the company business grow and prosper. On the other hand, the investors will face a much greater loss if the company operations do not prove to be successful. Aside from repaying the amount owed from the creditors, the company has to pay interest expense and may face credit risk of default.
Leverage magnifies both profits and losses. This is the reason why creditors and potential investors ask the question: How are the company assets being financed? To answer this, we will use two financial ratios:
- Debt to equity ratio – a measure of a company financial leverage in terms of actual amount
- Times interest earned – a measure of a company ability to cover interest expense
Debt to Equity Ratio
DEBT TO EQUITY RATIO = Total Liabilities / Shareholder's Equity
A high debt-to-equity ratio shows that the company has been aggressive in financing its operations with debt. As discussed, this is a good indication if the company business is able to increase its earnings with the help of the additional funds from creditors.
Capital-intensive industries such as airlines, car manufacturers and drilling operations usually have high debt-to-equity ratio because they usually require expensive equipment and raw materials in their operations. Creditors are usually willing to extend credit to these businesses when they see the viability of their operational and financial plans.
A low debt-to-equity ratio may indicate that the company is not taking advantage of the potential increase in profits that the company may earn with the additional financial leverage. But the company can take advantage of this when seeking new from potential lenders and vendors.
Times Interest Earned
A common measure used to assess a company ability to meet its debt obligations is Times Interest Earned which is computed as follows:
TIMES INTEREST EARNED = Earnings before Interest and Taxes (Operating Income) / Interest Expense
A high times interest earned ratio is favorable because it means that the company is earning more than enough profit and therefore has the ability to repay its debt and interest.
A times interest earned ratio of 1.5 and below is unsafe because it shows that the company is earning just enough profit before interest and taxes that is just enough to pay off its interest expense.
Debt financing is a good business strategy. But it is the management's responsibility to ensure that the borrowed funds are properly used in the business operations to increase profits. Without doing this, the debts will just cause additional problems to the company which may eventually lead to bankruptcy.