There are a number of assets that are used on the balance sheet to indicate the health of your company.
One standard ratio is the working capital ratio and that is the ratio of current assets over current liabilities and will tell the reader of a financial statement whether there are enough current assets that can be liquidated to be able to pay the current liabilities that are due.
The rule of thumb on this ratio has always been two to one. However, this ratio is really dependent on the kind of industry that the company operates in, so the rule of thumb may or may not always apply.
There are also many weaknesses with this ratio.
For example, if you have uncollected receivables that you haven’t written off to bad debts, then this ratio will be higher.
Another example is if you have obsolete inventory still listed in your current inventory, then this ratio will be higher.
That is the reason that when banks that are providing financing usually require an audit and part of the audit process is that the auditor must be present at the inventory count to determine whether the inventory is obsolete and should be written off.
Another ratio that can indicate that you have old receivables is the age of receivables ratio.
This ratio is 365 days divided by credit sales divided by average trade receivables (current and last period) with the result indicating how many days it takes to collect your accounts receivable.
The higher the number – the greater indication that you have uncollected receivables and a possible cash flow problem.
On the inventory side, there is the inventory turnover ratio which is much like the age of receivables ratio and is calculated by taking the cost of goods sold and dividing it by the average inventory (current and last period).
If you are tracking different classes of inventory, you should also be tracking different classes
of cost of goods sold so that you can perform this calculation on all your different classes by class to determine with better accuracy where the inefficiencies lie.
If you divide 365 days by the inventory turnover ratio you can also get an indication if you are stocking too much inventory.
If you are stocking too much inventory, then you may be experiencing a cash flow problem.
Moving to the liabilities section of the balance sheet, accounts payable is usually the largest payable listed and you can determine how many days it takes you to pay your payables by dividing 365 days by total purchases divided by the average accounts payable balance (current and last period).
The goal is to pay at your terms or just beyond your terms, because you certainly don’t want to incur any finance charges and you do want to take advantage of as many purchase discounts as possible.
You can also segregate your liabilities and purchases so that you do this ratio only on those payables and purchases related to inventory instead of the standard monthly overhead payables.
Again, if you are paying your purchases too soon, you may be experiencing a cash flow problem.
Banks also look at the ratio between the amounts due to creditors and the amounts due to the shareholders.
This is called the debt to equity ratio and it is calculated by taking the total liabilities and dividing it by the owner’s equity.
The bank wants to make sure that the owner is taking more risk than the creditors are with respect to the financing of the business.
The benchmark of this ratio has historically been two to one, but again this would be dependent on the kind of industry the company is operating in.
Another ratio that the banks look at is financial leverage.
This ratio is used to determine whether it would be more cost effective for the company to finance their growth by debt or by additional owners’ investment.
If the borrowing rate is lower than the investment rate, then it would make sense to borrow the money for growth rather than solicit additional investment from the shareholders.
In order to calculate this amount you would first need to calculate the return on total investment and also return on owners’ equity and the difference between the two numbers is your financial leverage.
Finally, the banks also want to make sure that current profits will be able to cover any interest expense incurred by the company.
The interest cover ratio is calculated by dividing the earnings before interest and taxes by the interest expense.
The benchmark is that this ratio must be greater than a value of two again dependent on the industry.
