Brass Tacks



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Just as financial ratios can help a business owner evaluate his or her firm’s status with respect to its liquidity, diagnostic ratios can assist in analyzing how a firm manages its debt. (Trade debt pertains to the credit extended by your vendors.): • Payables Ratio (cost of goods sold/trade payables): A high ratio indicates a shorter time between purchase and payment, so consider stretching out your repayment period. As a result, more cash will be available to your company for other purposes. But don’t let your ratio fall too far. For example, if you enjoy 30-day terms and there’s no discount for early payment, this ratio shouldn’t fall below 12 or whatever the standard is in your industry. A low ratio might indicate a cash shortage, sloppy record keeping or problems with suppliers. • Payable Period (cost of goods sold/payables ratio): This shows the average length of time that trade debt is outstanding. If your best terms call for payment in 30 days, this number should be 30. If this number is higher, you are endangering the nature of your relationship with creditors. You might consider stretching the acceptable payable period, giving you access to “other peoples’ money” for a longer period. Leverage ratios relate to the impact that your firm’s overall debt has on its financial health. • Debt to Equity (total liabilities/tangible net worth): This ratio illustrates the relationship between the capital invested in the firm by its owners and the funds contributed to it by its creditors. A low ratio indicates a high stake by owners and room for more borrowing. Prudent borrowing isn’t necessarily bad. An under-leveraged firm might be ignoring an opportunity to grow or diversify. A reasonable ratio — say 1:5 — shows that owners are making the most of resources available to them while still exposing themselves personally to the risk of loss or failure. If this ratio begins to climb, examine your operations for opportunities to downsize or scale back activity. Examine carefully what you are paying for the use of others’ money. It might be costing you more than what you are making on the operations it finances. • Debt to Assets (total liabilities/total assets): This ratio shows the portion of your firm’s assets that are funded by debt and offers a longer term perspective of the soundness of your business. Creditors obviously like to see a low ratio. Growing debt might signal a need to begin prepping for a supplementary round of equity-based capital from investors. Even if new debt financing is wise, it is better to get essential equity investors involved early so they can appreciate your plan for using new debt to good advantage. Coverage ratios show your company’s ability to carry the debt it has or is proposing to assume. • Debt to Interest (earnings before interest and taxes /interest): This ratio measures your firm’s ability to meet its interest obligations. A high ratio indicates strength in this regard. A low ratio is an early warning sign that something is amiss with your management style or business model. In a sales downturn that is not accompanied by a similar easing in interest rates, a high debt load can be devastating to a company as can having to reduce operating income in the face of stable interest costs. On the positive side, a high ratio suggests an ability to take on more debt. Interest rates, however, tend to move in cycles, and borrowing what is affordable today might become unaffordable as interest rates rise. • Current Coverage by Cash Flow ([net profit + depreciation, depletion and amortization expenses]/current portion of the long-term debt): This ratio drills in on your firm’s present cash capacity to carry its immediate interest and principal obligations. It also indicates whether you should be contemplating the accumulation of more debt. Naturally, the higher the number, the better. • Assets to Capital (net fixed assets/tangible net worth): This statistic reflects the strength of the foundation upon which your company functions. A low ratio indicates a conservative operation that can weather adversity or tap into credit markets to finance future growth or development. Keep in mind, however, that leased fixed assets may distort this ratio. A well-run business that’s in the game for the long haul should not let its net worth lie dormant. Excessive cash balances or liquid assets that are not being employed in the business suggest a complacent management style that could easily turn off prospective investors. Such a “cash stash” can also be a red flag to the IRS, indicating that your firm’s dividend policy is inappropriate. Paul Willax is a professor of entrepreneurship and chairman of the Center for Business Ownership Inc., Amherst, N.Y. He also is the author of the book, “Brass Tacks Tips for Business Owners,” available at barnersandnoble.com. If you have a question or suggestion for his column, or to receive a free, weekly e-mail newsletter, “Brass Tacks Brainfood,” write to Willax@TheBrassTacks.com. Edit ModuleShow Tags