Filed under Finance
by Ratio Rookie | May 20, 2012
I've heard that calculating "business ratios" from my financial statements would be helpful in running my store. What I haven't heard is why. Can you enlighten me?
Dear Ratio Rookie,
As we described earlier in this series, there are four major groups of statistics that are most commonly used to track business ratios. These four categories are (1) liquidity ratios, which we covered in Part One, (2) efficiency ratios, discussed in Part Two, (3) profitability ratios, reviewed in Part Three, and (4) solvency ratios, the topic of today's column.
The subject of our grand finale, Solvency Ratios, are sometimes called safety ratios—which is odd because they truly are risk ratios.
The ubiquitous debt to equity ratio (debt divided by equity) tells you the relationship between capital invested by the owners and capital borrowed from lenders. A ratio of 1:1 is fine. A ratio of 2:1 is about the max you'll get any lender to go on a small business. The higher the ratio, the higher the risk to the creditor. On the other hand, too low a ratio might mean you're not using all the leverage available to grow your business and enhance your returns.
The debt to asset (debt divided by assets) measures leverage—how much you've borrowed to finance your assets. If your debt exceeds 50 percent of assets, you'd better take a close look at how thinly financed you may be or possibly how undervalued your inventories, for example, might be. Using some debt to buy more inventory so you can increase sales, for example, might be a prudent use of leverage. But if your ratio is very high, reducing the amount of capital tied up in inventory might help bring things back down to a level of acceptable risk.
Interest coverage is computed by dividing operating income by interest expense. (Operating income refers to sales income remaining after cost of goods sold, selling expenses, and general and administrative expenses have been subtracted, but before interest expenses and taxes.) This ratio tells you how many times your earnings/cash flow can pay (cover) your interest charges. If this number starts to drop, it's a sign that you're headed for trouble.
Fixed charge coverage (profit before taxes and fixed charges divided by fixed charges) indicates your business's ability to meet all of its fixed expenses. These include rent, most salaries, property taxes, utilities, debt repayments and any other bills you need to pay every month whether or not you have any customers or income at all. This ratio often comes into play if you have a working capital loan; the lender will insist that a specific fixed charge coverage ratio be maintained or your loan will be called.
When working with these ratio tools, remember that, over time, inflation can wreak havoc with your periodic ratio comparisons and other distortions might be caused by changes in accounting methods. The examples we've used in these four columns are just a few of the dozens of ratios that can be tracked to better manage your business. The value of any given ratio will vary among different industries, and a good source for norms for your line of work might be your trade association.
Start tracking your solvency ratios, and don't forget to review your profitability ratios, as well as your liquidity ratios and efficiency ratios.