Four Critical Financial Ratios

Four Critical Financial Ratios
By Nick Harrison

Most startups fail due to financial issues. Potential investors are keenly aware of this.

Just as the captain of a ship posts lookouts on deck for signs of danger, an entrepreneur should make use of several financial ratios to determine whether the business is about to run aground. These ratios exist to measure and judge the status quo, and we review some key ratios in this document.

Through the use of these instruments, suboptimal outcomes can be foreseen and perhaps avoided.

A Review of Assets and Liabilities

Balance sheets categorize a company’s assets as either a current asset or a long-term asset. Current assets are expected to provide a benefit to the business within the next year. Long-term assets provide a benefit for more than one year.

An example of a current asset might be a certificate of deposit with a maturity of six months. A long-term asset might be a machine that is expected to operate for many years.

A company typically has several assets aside from cash on its balance sheet. The company can invest its cash in financial instruments like money market accounts, certificates of deposit, or U.S. Treasury notes. Because these investments can be converted into money rapidly, general accounting practices consider these to be cash equivalents. Cash and cash equivalents are considered current assets.

Similarly, a company has current liabilities and long-term liabilities. Current liabilities are those that come due within the next year. Long-term liabilities are those that will be paid off over the course of many years.

Return on Assets

One common measure of a company is Return on Assets (ROA). Return on Assets helps the would-be investor glean insight into how profitably a business is using its assets.

If Company A shows a ROA of 9% while Company B demonstrates a 23% ROA, we see that Company B is getting much more return on its assets. The higher ROA could indicate a competitive advantage that makes Company B an attractive investment. Conversely, if you are the owner of Company A, you may do well to examine how your competition is producing more profit per dollar of assets.

The ROA formula is:

ROA = Net Income / Average Total Assets

Net income can be found readily in a company’s income statement. Average total assets are calculated by adding the value of total assets at the start of the year to the value of total assets at the end of the year. Divide that sum by two.

Debt Ratio

The more debt a business assumes, the more likely the business will be unable to pay that debt. The debt ratio shows the percentage of assets that are financed with liabilities. The debt ratio formula is:

Debt Ratio = Total Liabilities / Total Assets

In spring 2017, Exxon Mobile had a debt ratio of 49% (162,989.00/330,314.00). The other 51% is financed by the stockholders of the company. By comparison, BP has a debt ratio of 64%. If an economic downturn occurs and fewer sales occur, which of these companies is more likely to default on their debts?

Current Ratio

More immediate are the current liabilities a company has: obligations that must be paid within the next year. The current ratio gives investors insight into the company’s ability to pay its near-term liabilities. To do this, we employ the following formula:

Current Ratio = Total Current Assets / Total Current Liabilities

The higher the ratio, the stronger the financial state. Using the outlet hardwood flooring company Lumber Liquidators, we get a current ratio for 8.86. This ratio reveals that for every $1.00 of current debt Lumber Liquidators must pay off in the next year, it has $8.86 on-hand!

On the other hand, at the time of this writing American Airlines has a current ratio of 0.76, which means the business has only seventy-six cents for every dollar of debt it must pay off in the next year. One business clearly struggles more than the other to pay its bills.

The Acid-Test Ratio (i.e. Quick Ratio)

The acid-test ratio is a more refined version of the current ratio. The total current assets used in the current ratio are not always readily convertible into cash (should the company need to pay off debt rapidly). Significantly, inventory is excluded when using the acid-test. The formula is:

Acid-Test = Cash & Equivalents + Market. Securities + Accts. Receivable / Total Current Liabilities

When we reexamine Lumber Liquidators with the acid-test ratio, we get a value of 0.22 – a much weaker showing than its current ratio. There are several interesting implications here. Lumber Liquidators is a company whose current value comes primarily from its inventory. It has relatively little cash on hand. The shrewd investor can take this information and try to envision situations in which an inventory-heavy company might suffer and then estimate how likely those episodes might occur.

American Airlines, whose current assets rely less heavily on inventory and more on cash and accounts receivable, has an acid-test ratio of 0.90.

Conclusion

Cash is the lifeblood of the business. Even when sales are good, business owners frequently seek out additional cash resources to grow the business – coming either from debt or equity. The information presented in the balance sheet, income statement, and cash flow statements are vital for external investors to decide whether to provision that money to the business. The ratios presented here provide operational insight not only for the potential investors but also for the current business owners.

Nick Harrison has 15 years of experience as a systems engineer. He is currently enrolled in the Western Carolina School of Business, pursuing a Master’s degree in Entrepreneurship. Webmasters and other article publishers are hereby granted article reproduction permission as long as this article in its entirety, author’s information, and any links remain intact. Copyright 2017 by Nick Harrison.

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