What lenders want - part 3: Accounting Ratios

In part three of our mini-series, we look at how lenders use the figures in your accounts to calculate accounting ratios and, from these, draw conculsions on the strength of your business.

Accounting ratios are a powerful tool for business lenders as they provide valuable insight into the financial health and performance of your business. This allows them to make more informed decisions.

Current ratio

The first ratio that is often used by business lenders is the Current Ratio. This ratio measures your company's ability to meet its short-term obligations by comparing its current assets to its current liabilities.

  • The formula for the current ratio is: Current Assets / Current Liabilities

A ratio of 2.0 or higher is considered to be healthy, as it indicates that your business has enough assets to cover its short-term liabilities.

However, a ratio lower than 1.0 may indicate that your business is at risk of making late payments or defaulting on its obligations.

Quick ratio

An extension of the Current ratio is the Quick Ratio. This ratio is similar to the current ratio, but it only takes into account the most liquid assets, such as cash and current debtors. Stock is often discounted as it can be difficult to realise quickly.

  • The formula for the quick ratio is: (Cash + Debtors + Short-term Investments) / Current Liabilities

A ratio of 1.0 or higher is considered to be healthy, as it indicates that a company has enough liquid assets to cover its short-term obligations.

Debt-to-Equity ratio

You knew it wouldn't be long before debt came into the picture!

This ratio measures the amount of existing debt your company has in relation to its equity. Put simply: if your business was liquidated tomorrow, how easily could it cover all of its borrowing.

  • The formula for the debt-to-equity ratio is: Total Debt / Total Equity

A high debt-to-equity ratio may indicate that your business is heavily geared and vulnerable to interest rate rises or a sudden change in market conditions.

A low debt-to-equity ratio, on the other hand, may indicate that your company is less risky, as it has more capacity to cover its debts.

Interest Cover

Quickly following the debt-to-equity ratio comes the interest cover ratio, which measures your company's ability to meet its interest expenses. Your lender is likely to include the interest on the facility you are requesting in this calculation.

  • The formula for Interest Cover is: Operating Income / Interest Expense

A ratio of 2 or higher is considered healthy, as it indicates that the company is generating enough income to cover its interest expenses two-times over.

A ratio lower than 2 can indicate that a company is at risk of defaulting on its interest payments if income was to fall by only a small amount.

Gross and Net Profit Margins

Your lender will be interested in how sustainable current business performance is and for this it will look at your profitability ratios. These ratios measure how much profit your company makes in relation to its revenue.

  • The formula for the gross profit margin is: Gross Profit / Revenue
  • The formula for the net profit margin ratio is: Net Profit / Revenue

Steady or improving margins are generally an indication that a company is well-managed and profitable on a sustainable basis.

Low or reducing margins, on the other hand, may indicate that your company is struggling to contain costs or increase its sales at a fast enough rate.

Return on Equity (ROE)

Lastly, the Return on Equity ratio measures how much profit your company generates in relation to its shareholders' equity.

  • The formula for ROE is: Net Income / Shareholders' Equity

A high return on equity ratio indicates that your company is making effective use of its capital and generating a good return for shareholders (probably, you!).

A low return on equity ratio, on the other hand, may indicate that shareholders' equity would be better invested elsewhere.

In summary

As we've mentioned elsewhere in this series, it is rare to find a perfect set of account, so don't despair if yours don't tick all the boxes mentioned here.

Most important to a lender is the margin of safety it can see if your business's fortunes turn south. No lender wants to be involved in a recovery situation, so the more it can see that you can accommodate a drop in sales, an increase in costs or maybe a bad debt or two, without putting excessive pressure on your business's viability, the more likely it is to say 'yes'.

Check out our other posts in this series to learn more about what lenders look for in your accounts.

Please get in touch if you have any questions. Our regulated brokers are experts in presenting accounts to business lenders and could make the difference between success and failure.

What lenders want - part 3: Accounting Ratios

By: Neil Edwards

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