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Home > Financing > Ratios

Financial Ratio Analysis

One of the tools the lender will use is financial ratio analysis. Ratios permit the review of a company's current financial performance versus that of previous years. In the same way that a medical check-up tests one's heart, lungs and changeable factors such as body weight, an analysis of a company's financial performance considers the status, changes and relationships of critical components of a company's health.

The lender also may use financial ratio analysis to consider how a company is doing when compared to another company. A limitation of such comparative analysis is that different industries are driven by different factors. As a result, the financial ratios of a manufacturer and retailer can be quite different event though both companies may be similarly successful.

Lenders are trained to appreciate both the benefits and limitations of ratio analysis and to consider financial results in the context of the company's "peer group" of similar companies within its industry. To find out what are the benchmarks fro your type of business, you may refer to guides published by Robert Morris Associates and others. These ratios are only a few of the many that are available to examine a company's financial condition.

Profit

Profit is the compensation an entrepreneur receives for the assumption of risk in a business venture. The profitable business must cover its overhead expenses and generate profits for its owner out of its "after-product-costs" cash. Two ratios that can be used to measure profitability include:

Gross Profit Margin: One of the commonly used measures of profitability is gross profit, which is the company's sales minus its product costs. In ratio it is called the gross profit margin:

Operating Profit Margin: Another measure of profitability is the operating profit margin. This is the core cash flow source that is expected to grow year to year as the company's business grows and it excludes interest expense, taxes and "extraordinary items" such as the sale of property or other assets.

Liquidity

Liquidity is a measure of how much cash the business has on hand for immediate use. Two measures of liquidity include:

Quick Ratio: The quick ratio shows what assets your business can immediately convert to cash, such as business checking account and money market accounts

Current Ratio: The current ratio is a broader indication of liquidity because it includes inventory. For purposes of showing your immediate access to cash, many lenders find it less useful than the quick ratio. In general, lenders look for your current assets to exceed your current liabilities.

Leverage

Leverage ratios measure the company's use of borrowed funds in relation to the amount of funds provided by the shareholders or owners. These ratios tell the lender how much money the company has borrowed versus the money that has been invested in the company by the owners. This is important because borrowed money carries interest costs requiring the business to generate sufficient cash flow to cover the interest and principal amounts due to the lender. Generally speaking, companies with higher debt levels will have higher interest costs to cover each month. Consequently, low to moderate leverage is nearly always viewed more favorably by prospective lenders.