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Financial Ratios and
Bank Financing






COPYRIGHT Ledgers Canada

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Financial Ratios and Bank Financing

Ratio Analysis involves measuring the proportional relationship between two single amounts. These may be
selected from one financial statement, such as the statement of income, or from two statements such as the
statements of income and financial position. The amounts may represent the balances of two different
accounts, the balance of one account and a classification total, such as total assets, or two classification
totals.

In evaluating the significance of ratios, consideration must be given to the purposes for which the ratios are to
be used. Investors, creditors and managers encounter different kinds of problems and decisions. Therefore,
different ratios are often meaningful to each group of users within the specific decisions that are to be made.

The following five categories of financial analysis ratios are the most commonly used:


Liquidity Ratios

These indicate the ability of the company to meet its short-term financial obligations when
they fall due.



Leverage-Capital-Structure Ratios

These indicate the ability of a company to fulfill its long-term commitments to debt holders.



Profitability Ratios

These indicate the level of profit generated by the company.



Turnover Ratios

These indicate the efficiency of the company in utilizing its assets.



Capital Market Ratios

These indicate a companys ability to win the confidence of the stock market.




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The following table illustrates the various ratio types, formula, classification and significance.

Ratio Formula Classification Significance


Earnings per Share
(common shares)
(Net Income Preferred
Dividends) Number of
Common Shares
Outstanding

Capital-Market Ratio
Tends to have an effect on
the market price per share,
as reflected in the price-
earnings ratio.




Fully diluted earnings per
share
(Net Income Preferred
dividends) (The average
number of common shares
outstanding +Average
number of common shares
issued on the assumed
conversion of convertible
securities)

Capital-Market Ratio
Shows the potential effect
on earnings per share of
converting convertible
securities into common
shares.


Price-Earnings Ratio
Market Price per share
Earnings per share

Capital-Market Ratio
An index of whether a share
is relatively cheap or
relatively expensive and a
measure of investor
confidence.


Dividend Payout Ratio
Dividends per share
earnings per share

Capital-Market Ratio
An index showing whether a
company pays out most of
its earnings in dividends or
reinvests the earnings
internally.


Dividend Yield Ratio
Dividends per share
Market Price per share

Capital-Market Ratio
Shows the dividend return
being provided by a share,
which can be compared to
the return being provided by
other shares.


Return on Total Assets
Net Income +[Interest
Expense x (1-tax rate)]
Average total assets

Profitability Ratio
Measure of how well assets
have been employed by
management.


Return on Common
Shareholders Equity
(Net Income Preferred
Dividends) Average
common shareholders
equity.

Profitability Ratio
When compared to the
return on total assets,
measures the extent to
which financial leverage is
being employed for or
against common
shareholders.


Book Value Per Share
Common shareholders
equity number of common
shares outstanding

Capital-Market Ratio
Measures the amount that
would be distributed to
holders of each common
share if all assets were sold
at their balance sheet
carrying amounts and if all
creditors were paid off.



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Ratio Formula Classification Significance


Working Capital
Current Assets Current
Liabilities

Liquidity Ratio
Represents current assets
financed from long-term
capital sources that do not
require near-term
repayment

Current Ratio Current Assets Current
Liabilities
Liquidity Ratio Test of short term debt-
paying ability


Acid-Test (Quick) Ratio
(Cash +Marketable
Securities +Current
Receivables) Current
Liabilities

Liquidity Ratio
Test of short-term debt
paying ability without having
to rely on inventory.


Accounts Recei vable
Turnover

Sales on account Average
accounts receivable
balance

Turnover Ratio
Measure of how many times
a companys accounts
receivable have been
turned into cash during the
year


Average Collection Period
(age of recei vables)

365 days Accounts
Receivable turnover

Turnover Ratio
Measure of the average
number of days taken to
collect an accounts
receivable.


Inventory Turnover
Cost of goods sold
Average inventory balance

Turnover Ratio
Measure of how many times
a companys inventory has
been sold during the year.

Average Sales Period
(turnover in days)
365 days Inventory
turnover

Turnover Ratio
Measure of the average
number of days taken to sell
the inventory one time


Times Interest Earned
Earnings before interest
expense and income taxes
interest expense

Profitability Ratio
Measure of the likelihood
that creditors will continue
to receive their interest
payments.


Debt to Equity Ratio

Total Liabilities
Shareholders Equity

Leverage-Capital-Structure
Ratio
Measure of the amount of
assets being provided by
creditors for each dollar of
assets being provided by
the shareholders.

Net Profit Margin Net Income Sales Profitability Ratio Measure of the companys
profitability.



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Ratios used by banks when determining credit worthiness


When a Small Business applies for credit with a bank, the bank will look at the following items:

Working Capital should be in line with the operating credit being requested.

Current Ratio a minimum of 1:1

Debt to Equity no higher than 2:1

Debt Service Coverage minimum of 125% coverage, calculated as Earnings before: Interest,
Taxes, Depreciation and Amortization debt payments to be made.

Accounts Receivable Consistent Turnover, with no negative trends and generally no more than
10% of receivables greater than 90 days, or in any one receivable making up more than 10% of the
total amount of receivables.

Inventory Consistent turnover, with no negative trends. Inventory is something that the banks are
reluctant to finance and do not take inventory values into great consideration when offering financing
or credit facilities.


One of the most important pieces of applying for credit in a small business is the personal position of the
principal owner of the business. If the owner is in good credit standing, relatively secure and has a good past
credit history, this may be enough for the bank to offer credit facilities. If the principle of the business is not in
good standing, they will take a closer look at the financial statements, ratios, and positioning of the business.



Although this is a generalization of the requirements of lending institutions, using these recommendations as
guidelines can dramatically improve your client relations by adding value to your services.




Using the Magic Carpets Inc. sample financial statements, we can calculate the ratios as follows in the chart
below:



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Ratio Formula Values Result Comment

Working Capital Current Assets
Current Liabilities
$62,036 $67,446 ($5,410) Poor, cash will not
satisfy obligations

Current Ratio Current Assets
Current Liabilities
$62,036 $67,446 0.92 Poor, cash cannot
satisfy obligations


Acid-Test (Quick)
Ratio
(Cash +Marketable
Securities +Current
Receivables)
Current Liabilities

($1,321 +$30,584)
$67,446

0.47
Poor, cash cannot
satisfy obligations

Accounts
Recei vable Turnover
Sales on account
Average accounts
receivable balance

$337,228 $30,584

11.02
Very good, credit sales
are well controlled

Average Collection
Period (age of
recei vables)
365 days Accounts
Receivable turnover

365 11.02

33.12
Very good, receivables
rarely extend beyond
terms

Inventory Turnover Cost of goods sold
Average inventory
balance
$135,245 $26,914 5.02 Good, Inventory is
turned over frequently
reducing risk of
obsolescence

Average Sales
Period (turnover in
days)
365 days Inventory
turnover
365 5.02 72.70 Fair, should consider
carrying less inventory


Times Interest
Earned
Earnings before
interest expense and
income taxes
interest expense

($18,571+2,679+3,532)
$6,211

3.99
Fair, Industry average
is considerably higher

Debt to Equity Ratio Total Long Term Debt
Shareholders Equity
$86,620 $23,647 3.66 Poor, however, large
portion of debt is due to
shareholders.
Reclassify shareholder
loans changes ratio to:
1.25 which is good

Net Profit Margin Net Income Sales $15,589 $337,228 4.6% Fair, Industry average
is considerable higher

Debt Service
Coverage
EBITDA Debt
payments obligation
$38,244 $18,216 2.09 Good, business is
earning considerably
more than is required to
service the debt
payments.




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Summation of this example:

The Current Ratio (0.92) is close to the required minimum of 1:1

The Debt to Equity ratio, when restated to exclude shareholder loans is within acceptable ranges
(1.25)

Debt Service Coverage is within acceptable ranges (minimum 1.25)

Accounts Receivable Turnover is very good (11.02)

Inventory Turnover is Good (5.02)

Therefore, assuming the credit history and personal financial status of the principles is satisfactory, the bank
would most likely approve this client for a small business loan to finance equipment purchases, or other
capital assets. The bank would also likely be inclined to extend a small ($10,000 - $20,000) line of credit to
the business in order to provide working capital.

Restrictions:

The bank, in its application of credit policies would likely place a restriction on the repayment of shareholder
loans as well as a freeze in the salaries of the managing partners.

The bank would require monthly financial statements of the business to maintain the approval of the line of
credit.

The bank would monitor the inventory turnover as well as the status of the accounts receivable each month.

The bank would require personal guarantees of the managing partner(s) of the business as well as a general
security agreement with the assets of the business being pledged as collateral.



By utilizing these simple ratio analyses, you can provide your clients with valuable insight into the credit
worthiness of the business as well as advising them of ways to bring the ratios in line with what may be
required by the banks when applying for financing.





Note: We thank TDCanada Trust for their assistance in the preparation of this information


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Ratio Analysis Advice for Clients:

Accounts Receivable Turnover and Inventory Turnover are probably the most easily changed values, and, by
increasing the turnovers, all other ratios can dramatically change.

For Example, assume a business has the following:

Current Assets: 59,000
Cash is 1,000
Accounts Receivable: 33,000 with 25% greater than 90 days
Inventory is 25,000
Current Liabilities: 75,000
Gross Margin on Sales of 40%

Therefore the following exists:

The working capital of the business is ($16,000) - very poor
The current ratio of the business is 0.78 - poor
The quick ratio of the business is 0.45 - poor

A bank would be reluctant to extend credit to this business in the above situation, however, if the business
reduced its inventory by 30% through sales and increased the collections on accounts receivable, bringing
the over 90 days to 5%, and assuming all cash generated is used to reduce current liabilities, the ratios would
become:

Current Assets: 44,900
Cash: 1,000
Accounts Receivable: 26,400
Inventory: 17,500
Current Liabilities: 50,900

Now, the following exists:

Working capital becomes: (6,000) -fair
Current ratio becomes: 0.88 -fair
Quick ratio becomes: 0.53 -poor

A bank would be more inclined to provide financing at this point, if all other items remained equal. Therefore,
by advising your client to keep inventory levels as low as possible and by focusing their efforts on accounts
receivable, they can put the business in a much more amendable financial position.

Other effects: In this example, the overhead would not theoretically change, therefore the net earnings
should have increased due to the sales of goods from inventory.

Accounts receivable turnover will have increased
Average age of receivables will have decreased
Inventory turnover ratio will have increased
Average age of inventory will have decreased


These trends in ratio changes would illustrate to the bank that the management of the company is making
changes to increase the performance of the business and to make the future operation of the business more
attractive to lending.



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Other suggestions to enhance the ratios:

If, in the above example, the principal of the business earns $4,000 per month in wages, and they were to
forego payment of wages for 1 month, assuming all other items remained equal, the following would exist:

Current Assets: 44,900
Cash: 1,000
Accounts Receivable: 26,400
Inventory: 17,500
Current Liabilities: 46,900

Now, the following exists:

Working capital becomes: (2,000) - fair /good
Current ratio becomes: 0.95 -good
Quick ratio becomes: 0.58 -poor
Net earnings will have increased -good


Consider converting short-term debt to long-term debt (debt consolidation) If the business has a
number of credit cards, lines of credit or other similar current obligations, provide a ratio comparative analysis
by converting the consolidated values to a term loan and review the effect on ratios and cash flow.

If, in the above examples, the company had $10,000 included in accounts payable that could be converted to
a 36-month term loan, the Current Ratio would become 1.21. The interest on the term loan would also be
considerably less than the interest on the credit cards, therefore increasing cash and net income.

Sale / Lease Back of Fixed Assets: There are businesses / lenders that specialize in this area. If a client
has a large amount tied up in fixed assets, they could evaluate a sale/lease-back option. This will
immediately increase cash and working capital, strengthening the Current ratio and the quick ratio.
Depending on the type of lease (operating vs. capital) the net earnings of the business could be affected, a
detailed analysis of the net effect of this option must be completed before recommending to the client.

Employees and Payroll: Payroll is one of the largest expenses of virtually all businesses. A business owner
should review frequently the staffing of the business. By reducing the payroll costs, the savings if applied to
accounts payable will strengthen working capital, the current ratio, the quick ratio and the net earnings of the
business. Can some of the employees be converted to part-time? Could certain positions be better served
by contract employees or outsourcing? Could benefit costs be reduced without harming employee relations?

Reduction in pre-paid expenses: Does the client have prepaid insurance, taxes, utilities or other items?
Converting these expenses to a monthly payment plan, would increase cash flow, and allow for the reduction
in current liabilities. Therefore strengthening the ratios.


Essentially, any cost savings the business can realize will strengthen net income, and, all other items
remaining equal will improve the ratios that lending institutions look at.