Article by Roger Schlueter, MBA
My Favorite Ratios are all you need but they are widely used Ratios. Most of these ratios are used for financial analysis and therefore should be used together. Most good banks will put your financial statements on a Spread Sheet which lines the financials up next to each other and usually makes many of the calculations we will show you here automatically on the Spread Sheet.
This Spread Sheet will be looked at and some calculations will be made like:
A) Percent of increase or decrease in Sales, COGS, and other costs over the periods – years, months etc. This will identify trends of Sales and Costs involved with the business. The Ratios will also be looked at over time periods – years, months etc.
My Favorite Ratios:
1) Debt to Equity = Measure of Financial Risk. It is the Number of Dollars of Debt Owned for Every Dollar of
Equity.
Example
You have Debt of $40,000 and Equity or Net Worth of $10,000. You would have a Debt to Equity Ratio of
4.0
Debt / Equity = Debt to Equity Ratio
The lower the Ratio, the lower the Perceived Risk. A Ratio of 4 to 1 is about average and the lower it is,
the less risk and the higher the ratio the higher the risk to the Bank.
2) Current Ratio = Measure of Solvency. It is the Number of Dollars of Current Assets (Cash, Accounts
Receivable, Inventory, other Current Assets) for Every Dollar of Current Liabilities (Notes Payable-Current
Portion, Accounts Payable, Other Current Liabilities).
Example
You have Current Assets of $40,000 and Current Liabilities of $20,000. You would have a Current Ratio of
2 to 1.
Current Assets / Current Liabilities = Current Ratio
The Higher the Ratio the better. A Ratio of 2 to 1 is about the norm but Higher is preferable and Lower is
dangerous because the bank will feel that there are not enough assets to cover the liabilities over the
next year.
3) Quick Ratio = Measures Liquidity. It is the Number of Dollars of Cash and Accounts Receivable for Every
Dollar of Current Liabilities (Notes Payable-Current Portion, Accounts Payable, Other Current Liabilities).
Example
You have Cash of $10,000 and Accounts Receivable of $10,000. You would have a Current Ratio of 1 to
1.
Cash + Accounts Receivable / Current Liabilities
The Higher the Ratio the Better. A Ratio of 1 to 1 is the norm but Higher is preferable and lower is
dangerous because the bank will feel that there is not enough Cash and Coming Cash (Accounts
Receivable) to pay the Bills over the next year.
4) Days Accounts Receivable = Measures the Days that it takes to collect Account Receivables ( Money owed
to you). This can be done two ways and I will show you the easiest and quickest way to get the Days
Accounts Receivable. The Number of Dollars of Accounts Receivable divided by Sales and then multiplied
by 360.
Example
You have $168,000 of Accounts Receivable and $930,000 of Sales. You would have a Days Receivable of
65 days.
Accounts Receivable / Sales * 360
This is the quickest way to get the Days Receivable. The Days in themselves do not mean much but the
trends over the years, months, etc. it will show if your customers are paying on time and if these trends
are getting better or worse.
The other way is to get the Turnover Rate first, Sales / Accounts Receivable = A/R Turnover Rate. Then to
Divide the days in the year – 360 by the Turnover Rate. you can do the same with the Days Accounts
Payable and Days Inventory.
5) Days Accounts Payable = Measures the Days that it takes before you pay your bills. The Number of Dollars
of Accounts Payable divided by the Cost of Goods Sold and then multiplied by 360.
Example
You have $30,000 in Accounts Payable and $323,000 in Cost of Goods Sold. You would have a Days
Payable of 33 days.
Accounts Payable / COGS * 360
This means that you pay in 33 days. If that is the time period that is allotted then you are paying your bills
then that is fine. This would be different if you needed to pay in 30 days and your Days Payable was 60
days – your paying late. If the days payable is very low the company could be on COD which is not good
either. Again these mean less taken by themselves and are looked at over a period of years, months
etc.
6) Days Inventory = Measures the Days of Inventory that you have on hand to fill orders. The Number of
Dollars of Inventory divided by the Cost of Goods Sold and then multiplied by 360.
Example
You have $100,000 in Inventory and $323,000 in Cost of Goods Sold. You would have a Days Inventory of
111 days.
Inventory / COGS * 360
This means that you have 111 Days of Inventory. Sound like a lot but it depends on the industry. Again it
needs to be looked at over a period of years, months, etc.
You need to Know What These Ratios and Calculations Are before going the the bank. You do not want to give that, “Deer in the Headlights” Look when discussing your Financials and the loan that you need for your business. Bankers will put your Financials on a Spreadsheet and Analyze them for Advantages and Weaknesses, You need to do the Same.
Please email me at roger@rogerschlueter.com for any questions or comments on this blog. I also have a website at schlueterfinancial.com