Do you know the long-term Financial Health of Your Business?
For the past 18 months, many small to medium-size businesses have seen a disruption in their business operations. Things are no longer the same as they used to be. Chief amongst the many concerns is managing cash flow, which has been one of the key challenges for most business owners.
As a result, many businesses have turned to their lenders to take out new loans to see them through the crisis. As the pandemic shut down or slowed businesses, companies had to draw down their line of credit or cash and used various levels of government implemented financial relief measures in the form of long-term debt to ensure that companies had enough cash to stay in business.
There are many financial ratios you can use to monitor the long-term financial health of your business but the ratios we’ve provided here are the main ones to use when checking the financial health of your business and are easy for you to use.
1. Leverage Ratios
Three leverage ratios to monitor your financial health from a debt perspective.
As the economy opens up it’s important for businesses to determine the current state and see how leveraged the business is. The leverage ratio (Leverage ratio = Total Liabilities / Equity) indicates the extent to which the business is reliant on debt versus equity to fund the assets of the business.
This is one of the best ways to assess how much debt a business can carry, and if they can properly manage this debt. These ratios provide an indication of the long-term solvency of a company and to what extent you are using long-term debt to support your business. In most cases the higher the ratio, the more difficult it will be to obtain further debt funding.
• Debt-to-equity ratio
This ratio is slightly different and is measured by dividing your total liabilities by shareholder equity. It shows the mix of how much of the businesses assets are financed by debt vs owners’ investment. Lenders watch this indicator closely as a measure of how much the owners are invested in the business vs how much lenders are funding the assets. A lower ratio indicates that the business has better debt capacity and can potentially raise new funding through debt.
• Debt service coverage ratio
The debt service coverage ratio measures a company’s ability to make debt payments on time. It is calculated by taking a company’s earning before interest, taxes, depreciation, and amortization (EBITDA) and dividing it by annual interest and principal payment expenses for all existing and proposed debt.
Essentially, the debt service coverage ratio shows how much cash a company generates for every dollar of principal and interest owed. The EBITDA should be able to cover interest and principal payments and still leave some leftover earnings to retain and invest back in the business.
• Debt-to-asset Ratio
The debt-to-total-assets ratio shows the percentage of a company’s assets financed by creditors. A high ratio indicates a substantial dependence on debt and could be a sign of financial weakness. The debt-to-total assets ratio is primarily used to measure a company’s ability to raise cash from new debt. That evaluation is made by comparing the ratio to other companies in the same industry. The debt-to-total-assets ratio is calculated by dividing a company’s total debt by its total assets.
2. Liquidity Ratio
The liquidity ratio helps to assess your business’ ability to pay its bills – indicating the ease of turning assets into cash. In most cases, it’s better to have higher ratios in this category than current liabilities as an indication of sound business activities and an ability to withstand tight cash flow periods.
3. Current Ratio
As one of the most common measures of financial strength, this ratio measures whether the business has enough current assets to meet its debts with a margin of safety. Current ratio = Total current assets / Total current liabilities. An acceptable current ratio depends on the nature of the industry and the form of its current assets and liabilities.
4. Quick Ratio
Sometimes called the ‘acid test ratio’ (Quick ratio = Current assets – stock on hand / Current liabilities), this is one of the best measures of liquidity. By excluding stock which could take some time to turn into cash unless the price is “knocked down”, it concentrates on real, liquid assets.
It helps answer the question, If the business doesn’t receive income for a period, can it meet its current obligations with the readily convertible ‘quick’ funds on hand?
5. Solvency Ratio
Solvency ratios indicate the extent to which the business is able to meet all its debt obligations from sources other than cash flow. It will help you assess that If the business suffers a reduction in cash flow, will it be able to continue to meet the debt and interest expense obligations from other sources?
Creating a plan to help you through the recovery
We suggest that you look beyond 12 months and start to create budgets and plans for your recovery. You will have a clear understanding of your own financial health and debt servicing capacity and begin to establish the needed discipline to stay on track. You will have more peace of mind because you have quantified the uncertainty and build a mitigation plan to address them.