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Four Critical Financial Ratios
Most startups fail due to financial issues. Potential investors are aware of this.
Just as a ship’s captain posts on deck to look for danger signs, an entrepreneur must use a number of financial ratios to determine whether a business is going to work. These ratios exist to measure and justify the status quo and we review some key ratios in this document.
Through the use of these tools, sub-optimal results can be predicted and possibly avoided.
Review of assets and liabilities
Balance sheets classify a company’s assets as current assets or long-term assets. Current assets are expected to benefit the business in the next year. Long-term assets provide benefits for more than one year.
An example of a current asset would be a certificate of deposit with a maturity of six months. A long-term asset may be a machine that is expected to operate for many years.
A company’s balance sheet consists of many assets other than cash. The Company may invest its cash in financial instruments such as money market accounts, certificates of deposit or US Treasury notes. Because these investments can be quickly converted into cash, common accounting practices treat them as cash equivalents. Cash and cash equivalents are considered current assets.
Similarly, the company has current liabilities and long-term liabilities. Current liabilities are due within the next year. Long-term liabilities are those that will be paid off over a period of years.
Return on Assets
A common measure of a company is return on assets (ROA). Return on assets helps investors gain insight into how profitably a business is using its assets.
If Company A shows a 9% ROA while Company B shows a 23% ROA, then we see that Company B is getting a higher return on its assets. A high ROA may indicate a competitive advantage that makes Company B an attractive investment. Conversely, if you own Company A, you might do well to examine how your competition is making more profit per dollar of assets.
The ROA formula is:
ROA = Net Income / Average Total Assets
Net income can easily be found in a company’s income statement. Average total assets are calculated by adding the value of total assets at the beginning of the year to the value of total assets at the end of the year. Divide that sum by two.
The more debt a business has assumed, the more likely it is that the business will be unable to repay the debt. Debt ratio shows the percentage of assets financed with liabilities. The debt ratio formula is:
Debt Ratio = Total Liabilities / Total Assets
In the spring of 2017, Exxon Mobile’s debt ratio was 49% (162,989.00/330,314.00). The other 51% is financed by the company’s stockholders. In comparison, BP’s debt ratio is 64%. If an economic downturn occurs and sales decrease, which of these companies is more likely to default on their debt?
Current liabilities the company has are more immediate: must be paid within the next year. The current ratio gives investors an insight into the company’s ability to meet its near-term obligations. To do this, we use the following formula:
Current Ratio = Total Current Assets / Total Current Liabilities
The higher the ratio, the stronger the financial position. Using the outlet hardwood flooring company Lumber Liquidators, we get a current ratio of 8.86. This ratio shows that for every $1.00 of current debt Lumber Liquidator must pay off in the next year, he has $8.86!
On the other hand, American Airlines’ current ratio at the time of this writing is 0.76, meaning the business has only seventy cents for every dollar of debt that must be paid off next year. One business obviously struggles more than another to pay its bills.
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 cannot always be converted into cash (if the company needs to pay off debt quickly). Significantly, the list is omitted when using the acid-test. The formula is:
Acid-Test = Cash and Equivalents + Market. Securities + Acts. Receivables / Total Current Liabilities
When we re-examine the Lumber Liquidators with the acid-test ratio, we get a value of 0.22 – much weaker than the current ratio. There are several interesting results here. Lumber Liquidators is a company whose current value comes primarily from its inventory. There is relatively little cash in hand. A smart investor can take this information and try to imagine a scenario in which an inventory-heavy company might suffer, and then estimate the likelihood of that happening.
American Airlines, whose current assets rely less on inventory and more on cash and accounts receivable, has an acid-test ratio of 0.90.
Cash is the lifeblood of business. Even when sales are good, business owners frequently seek additional cash resources to grow the business—either from debt or equity. Information presented in the balance sheet, income statement, and cash flow statement is essential for outside investors to decide whether to commit that money to the business. The ratios presented here provide operational insights not only for potential investors but also for existing business owners.
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