Why Monitoring Financial Ratios Is Critical To Sustaining Your Business Financing
Financial ratios are used to evaluate the overall financial performance of a company. These ratios compare numerical values taken from a company’s financial statements to indicate the company’s profitability, liquidity, financial risk, and working efficiencies.
Too often, businesses focus on their financial ratios as they work to secure a business loan — then take their eye off the ball once funding is in place. This can be a devastating mistake. As harsh economic conditions continue, keeping a close watch on your financial ratios can be crucial to business survival – in more ways than you may think.
In this article, we look at what financial ratios are, what they reveal about your business, and why it’s critical to monitor them. We’ll then discuss alternative business financing options less dependent on financial ratio monitoring. These alternative funding options provide more flexibility and allow your business to improve financial ratio results rather than being controlled by them.
What are financial ratios?
Financial ratios are the comparison of two data points taken from a company’s financial statements to produce easy-to-assess results. By comparing various line items from a company’s financial statements, a business’s owner, potential lenders, and other stakeholders can evaluate its revenues, profits, efficiency, liquidity, leverage, and more. Using trend analysis, stakeholders can track a company’s growth over time, and compare financial performance with industry competitors.
What do financial ratios reveal?
Monitoring financial ratios is like looking in the mirror – it’s a stark reality check! A wide range of stakeholders, including management, investors, and financial professionals, rely on financial ratios to learn about your company’s:
- Ability to pay bills
- Access to working capital
- Inventory management efficiency
- Debt exposure
- Asset utilization
- Cash flow
- YoY and MoM performance
- Competitor analysis
- And much more!
The ratios best suited for your company depend on your business category and industry. However, there are common ratios that commercial businesses should regularly calculate to monitor business stability and fine-tune their business decisions. These include the following:
Quick ratio (quick assets / current liabilities):
This calculation is a quick method to measure a company’s ability to meet short-term payments with its most liquid assets, such as cash, marketable securities, and net accounts receivable. This ratio assesses whether a company can cover its current liabilities without selling its inventory or obtaining additional financing. A ratio of 1 or greater is considered healthy. For example, a quick ratio of 2 means a company has 2 dollars of assets to cover 1 dollar of current liabilities. Learn more.
Working Capital Ratio (current assets / current liabilities):
This ratio is a more detailed calculation to compare a company’s total assets that can be converted into cash within 12 months against total current liabilities. A ratio of 1.5 or higher indicates increased financial flexibility to expand operations, while a ratio below 1 indicates a negative cash flow. Stakeholders use this ratio to determine a company’s short-term financial health. Learn more.
Inventory turnover (costs of goods sold / average value of inventory):
Measuring inventory turnover assesses the condition of a company’s inventory by dividing the cost of goods sold (COGS) in a set period by the average value of inventory over the same length of time.
Generally, the higher the ratio, the better, as it most often indicates strong sales. However, be cautious: a ratio that is too high may mean your company isn’t purchasing enough inventory to support the rate of sales. A lower ratio can point to weak sales or decreasing market demand which will probably result in the goods being overstocked. Most industries’ ideal inventory turnover ratio will be between 5 and 10. However, as each industry has different ideal values for inventory turnover, it is essential to know and compare your ratio to the standard for your business sector. Learn more.
Debt-to-Equity ratio (total liabilities / total shareholders’ equity):
Debt-to-equity ratio measures the company’s total debt in relation to its equity. This in turn indicates the degree to which a company is financing its operations with debt rather than its resources. Conventional lenders watch this ratio closely to determine if a company is over-leveraged. Although it varies from industry to industry, a debt-to-equity ratio below 1 would be seen as relatively safe, whereas values of 2 or higher might be considered risky. Learn more.
EBITDA margin (earnings before interest, taxes, depreciation, and amortization / total earnings):
This metric is a profitability ratio. It measures how much in earnings a company generates before interest, taxes, depreciation, and amortization, as a percentage of revenue. Earnings are calculated by taking sales revenue and deducting operating expenses. EBITDA margins can indicate a company’s performance levels and ability to generate cash flow. A “good” EBITDA margin varies by industry, but a margin over 10 is considered good. Over the last several years, the EBITDA has ranged between 11 and 14 for the S&P 500. Learn more.
Cash conversion cycle (days of inventory outstanding + days of sales outstanding – days payable outstanding):
Measures how quickly (in days) a company converts inventory and other resources into cash through sales. A good cash conversion cycle (CCC) is a short one and indicates healthy cash flow. If your CCC number is low, your working capital is not tied up for long, and your business has greater liquidity. Research indicates the median cash conversion cycle is between 30 and 45 days. Learn more.
By now, you should have a sense of why it’s critical to monitor your company’s financial health using ratios – but there’s another reason. Most business financing providers not only use ratios to assess your loan: they also monitor your financial ratios on an ongoing basis to ensure you live up to your loan commitments.
The importance of financial ratios to maintain business financing
Financial ratios are used by lenders to qualify a company for business financing and to set benchmark levels that are then built into the loan’s covenants. Financial ratios are reviewed to measure results against benchmarks and verify continued compliance with the loan’s covenants. If covenants are breached, lenders may act quickly to mitigate risk, resulting in credit restriction or a credit recall. Most conventional lenders require regular financial reporting from borrowers. Don’t be caught off guard – know your financial condition before your lender!
The key here is to pay close attention to your ratios every month to stay one step ahead of your lender throughout the repayment period. Don’t just print off reports monthly and submit them to your lender without understanding the results. Stay ahead of the bank and know how your financial performance is trending. If your company’s financial performance is trending in the wrong direction, take steps to right the ship. If things can’t be corrected quickly enough, you should be prepared to transition to an alternative funding source if needed.
Be prepared to transition
The insights you get from your company’s financial ratios help shape the strategic direction of your business. For instance, if your ratios indicate your company cannot maintain good standing with your current lender, then it’s essential to improve financial performance and consider alternative funding sources.
And since increasing revenue and reducing costs to enhance your bottom line is an uphill battle in today’s sluggish economy, switching to a more flexible lending alternative is becoming an even more practical and faster option to maintain reliable funding. If any concerns surface in your monthly ratio analysis, be proactive and take steps to be prepared for a quick and seamless transition to a flexible funding solution. Look for alternative financing that provides funding options with tailored features aligned with your business goals and minimal covenants to provide maximum flexibility.
Flexible funding options with minimal ratio monitoring
Alternative finance companies provide flexible funding solutions that conventional lenders generally can’t match. Using advanced technology to access vast databases and credit-related data points, alternative finance companies manage credit risk with minimal loan covenants. Rather than leaning heavily on a set of financial ratios, alternative finance companies require few conditions, such as representations and warranties stating that the customer has insurance in place, is up to date with their taxes, and complies with the law. Other conditions may include monthly minimums and borrowing base reporting depending on the funding solution.
Following are three commonly used alternative funding options with few covenants and more flexibility to support growth:
Invoice factoring is the selling of your company’s outstanding receivables to a third party at a discount in exchange for immediate cash. It’s a popular funding choice for companies that regularly issue invoices to creditworthy customers but can’t wait 60-90 days to receive payment. Monthly minimums may be required, but no financial ratio monitoring is typically mandated.
Asset-based lending is a popular way of financing that uses your company’s assets, such as inventory, receivables, equipment, or machinery, as loan collateral. It offers more creative and personalized “outside-the-box” solutions than a conventional line of credit and delivers funds much faster. Generally, borrowing base reporting is required, but few other conditions are attached.
Equipment refinancing provides a large influx of cash to maximize access to working capital. Assets already owned by the business can be refinanced to raise capital, consolidate debt, or replace existing debt using the equipment as collateral for the loan. Industry-leading alternative lenders provide advancements up to 75% on net orderly liquidation value. Depending on the lender, only minimal covenants, like a relaxed form of borrowing base monitoring, are required.
Tracking financial ratios is an effective way to examine a company’s financial health. Regular monitoring provides clear insights to help management guide strategic decisions to improve efficiency and performance. But they are also critical in sustaining your business loans.
If a negative trend in the borrower’s financial health develops, the lender may take corrective action to mitigate the risk. This could result in a change of terms, the restriction of credit, or worse, a credit recall.
Taking your eye off the ball by paying less attention than your lender to your financial ratios is potentially devastating. This is especially true during economic downturns when conventional lenders monitor their lending portfolios carefully.
Regularly monitor financial ratios and look for poor performance that may cause your lender to take risk-mitigating action. Assessing your company’s financial ratios keeps you informed of your company’s financial status and provides the same view into your business that your lender sees. If you feel your business financing may be in jeopardy, investigate flexible alternative financing options like invoice factoring and asset-based lending.
Reputable and experienced alternative finance companies can facilitate a seamless transition to flexible funding if your current lender is no longer the best solution for your business financing. Reach out to alternative finance companies to discuss your situation, assess their services, and set plans to restructure your business financing with flexible funding options free from extensive lender oversight and financial ratio monitoring.
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