Study ratios to gauge business health

As the economy slowly improves, the romance between confidence and optimism begins to bloom again. Companies begin to expand and need money to finance their growth, and, not by coincidence, banks and investors just happen to be more interested in lending money to business enterprises.

While the timing is perfect, this is a modern romance and there is one complication. Today’s banks and investors have this set of close friends that always seem to be around. They call themselves “financial ratios” and if a financial relationship is ever going anywhere, a business just has to figure a way to get along with them.

Financial markets have changed a lot in recent times and not just because of technology. More significant, really, is that millions of people were cut loose from their pension plans and found themselves responsible for their own financial futures — and the investment decisions and knowledge, including financial ratios, that went with that responsibility.

From the standpoint of a smaller business, though, financial ratios often seem to be, at best, a luxury — used by those few who have the time and the resources to be analytical about their companies. For the harried business owner, especially a first-time borrower, these ratios can seem to be just one more hoop to jump through.

Spending some time with a bank’s lending officer, however, can help explain how financial ratios can be useful to both borrower and lender.

Lisa Forrest is Union Bank’s vice president for Small Business Administration lending in Washington and Oregon. Based in Everett, she’s an experienced lending officer who is very familiar with the demands placed on the owners and managers of smaller businesses.

“Business owners wear multiple hats,” she says, “and their first responsibility is to run the business and make it successful.” As a result, “they rarely have an opportunity to focus on their firm’s financial ratios.”

Her experience with the realities of small business management has helped her develop an approach to financial ratios that can bridge the gap between lenders, for whom these ratios are very important, and business owners, who often do not see how financial ratios fit into the day-to-day management of the operation.

The heart of Forrest’s approach to financial ratios for a smaller business is to concentrate on the essentials. “Most business owners come to understand how useful the key ratios are when they are directly linked to the three areas of a business that managers deal with nearly every day,” she said. “One, liquidity. Two, leverage and solvency. And three, profitability.”

The basic, shirt-pocket financial ratios in these three areas are much like the vital signs and basic information used by medical professionals for emergency care or a physical. They do not tell everything about a business or a patient, but they are always a good place to start.

Liquidity measures the cash a business can generate to pay its debts. The financial ratios used to look at liquidity are the current ratio and the quick ratio.

The current ratio is simply the business’s current assets divided by its current liabilities. The quick ratio subtracts inventory from current assets and then divides it by current liabilities. These ratios indicate a business’s general ability to pay its bills on time and are mostly used to highlight any sort of maturity mismatch. It is easier than you might think for a business to get its incoming and outgoing cash payments out of sync and end up with plenty of profits but angry phone calls from suppliers.

Leverage and solvency are the bookends of a business. They measure how much the business depends on “other people’s money” (leverage) and the ability of a business firm to meet its total obligations (solvency).

Leverage is measured several ways, but the starting place is almost always the debt ratio, which is the firm’s total liabilities divided by its total assets. There are several measures of solvency but the initial solvency ratio is calculated by adding after-tax net profit to depreciation and dividing that sum by the firm’s total liabilities.

The profitability, or performance, shows up in its return on assets (ROA), which is its net income divided by its total assets, and in its return on equity (ROE), which is its net income divided by its average equity.

There are many more financial ratios that may be useful to you, to a lender or to an investor. However, business owners and managers should start with understanding these six fundamental ratios and the story that each tells. They are the building blocks of a good relationship between your business and those who provide the funds to finance its growth.

James McCusker is a Bothell economist, educator and small-business consultant. He can be reached by email at otisrep@aol.com.