When the economy went south in the 2008 downturn, many companies found themselves moved into the special assets department of their bank or pushed into a high-interest factoring arrangement.
Suddenly those ratios that the banker included in the loan covenants took on significant meaning. A few years of losses ate away at equity built up over years and that once solid bank relationship became all about the numbers.
While owners may find it tempting to stick to a factoring or asset-based lending arrangement and keep the banker’s at arms’ length, the cost of money is often too significant to brush off.
An asset based lender may be charging 10-12% the borrowing against receivables. Invoices that are factored could carry interest charges of 8-12%. While bank loans are being offered at prime +1%, or 4.25%. On a few million dollars of credit, that’s significant money.
But before it’s time to go knocking down the doors of the nearest bank, take a look at these two basic ratios:
This ratio compares a company’s total liabilities to its total equity. It measures how much suppliers, lenders and creditors have committed to the company compared to what the shareholders have committed, both in initial investment and profits retained in the company.
Debt-to-Equity = Total Liabilities / Total Equity
The “right” number varies by industry, but a good place to start is 3:1. Bankers generally don’t like to see leverage that is higher, but may be flexible if there has been a steady downward trend and that ratio is in near reach.
This ratio measures liquidity, a company’s ability to pay short-term obligations. It is used to evaluate the company’s ability to pay back its short-term liabilities (debt and payables) with its short-term assets (cash, inventory, receivables). The higher the current ratio, the more liquid the company is. A ratio of less that 1:1 means the company could not pay off its bills. The Current Ratio formula is:
Current Ratio = Current Assets / Current Liabilities
Bankers typically like to see a current ratio of at least 1.2.
These two very key ratios should be monitored by all business owners, regardless of whether or not they are planning to seek new financing.
One suggestion is to incorporate them into the monthly financial reporting. Put them right at the bottom of the balance sheet that is generated each month. Set up a chart to track them over time and against a goal.
Once owners start monitoring these ratios themselves, they become the kind of business that all banks want in their portfolios.
And, what business owner want to pay more interest? There are much more productive uses of that hard earned cash.