Last month I wrote about the current ratio and the acid test, two key ratios that tell you whether you have enough money coming in to pay your bills in a timely fashion. This time I'll cover three other key ratios.
Accounts receivable to accounts payable (AR/AP)Like the current ratio and the acid test, the accounts receivable to accounts payable ratio is a measure of liquidity. You calculate this ratio by looking at the balance sheet. It is calculated by: Accounts Receivable/Accounts Payable.
Be careful to use only trade receivables and trade payables (i.e. receivables from customers and payables to suppliers). Do not include any receivables or payables from employees, officers, friends, relatives, etc. If 50% or more of your sales are C.O.D., then use trade receivables plus cash, divided by accounts payable to determine this ratio.
The ratio should be 2 or higher. If it is under 1 then your company is probably in trouble. Sales and receivables are not great enough to cover what is owed to suppliers. If this is the case, then look at pricing very carefully. You are probably not charging enough to cover expenses. You are "robbing Peter to pay Paul."
Debt to equityThis financial ratio is a measure of capitalization of the company. The debt to equity ratio looks at how much debt your company has in relation to the worth of the company. If you have a negative net worth, this means that you have more debt than you have assets to cover the debt. It usually means that the company has not been profitable. You must turn the company around if you want it to survive.
Most contracting companies are undercapitalized, meaning that the majority of money that was put into it is a stock investment. You can calculate this ratio by looking at the balance sheet. It is calculated: Total Liabilities/Total Equity.
Total liabilities include both short term and long term liabilities. Total equity is stock, paid in capital, retained earnings, etc. - anything that is listed under the Stockholder's equity or Net Worth segment of the balance sheet.
This ratio should also be as low as possible. However, for most contracting companies, it is around 2 to 3. It should definitely not be negative!
If the ratio is negative, it means that the net worth of the company is negative. If the company is seeking a bank loan, very few bankers will extend loans when a company has a negative net worth unless there are extenuating circumstances and there are assets that the company can pledge. A negative net worth means that the company is probably in trouble because it has been losing money for a long period of time.
Long-term debt to equityThe long-term debt to equity ratio is also a measure of capitalization. You calculate this ratio by looking at the balance sheet. It is calculated: Long-Term Liabilities/Total Equity.
Again, make sure that items that should be listed in long-term liabilities are listed there. If there are bank loans and no current portion of these loans is listed, then this ratio will be overstated. This ratio should be less than one. It should definitely not be negative! (See the explanation for Debt to Equity).
I have a tendency to put a low importance on the debt to equity ratio unless it is negative. Most hvac companies are undercapitalized, which means they used more debt than cash to start and grow their companies.
This shows up to these two ratios. if the company is liquid and not losing money, I place more emphasis on the liquidity of the company rather than its debt and equity structure. if the current ratio, acid test, accounts receivable to accounts payable and long term debt to equity ratio are within industry standards, I discount the debt to equity ratio if it is high. Even if it is high, the company still has the liquidity to pay its bills on time.
Remember, these ratios and guidelines have been developed for the contracting industry. I have no clue as to whether they hold true in other industries since I don't work with companies other than contracting firms.
We'll continue with our discussion of important financial ratios next month.
Copyright 2000, Ruth King. All rights reserved.