Over the last two weeks I wrote about how the three main financial statements of your business contain five sections as follows:
- Assets (the things you own)
- Liabilities (what you owe)
- Equity (what’s leftover for you)
(the above 3 sections are on the Balance Sheet)
- Revenues (the inflows into your business)
- Expenses (the outflows from your business)
(the above 2 sections are on your Income Statement)
To understand the story of your business month by month, year by year you need a sharper focus.
That sharper focus can begin with ratios.
Two weeks ago I wrote about liquidity ratios and profitability ratios.
Last week I wrote about Activity Ratios, namely Average Days Inventory, Average Days Receivable, Average Days Payable, and Cash Conversion Cycle.
This week I will write about…
Leverage Ratios
Leverage ratios measure the overall debt level of a business.
It is an indication of the business’s ability to repay new and existing loans.
A very low ratio can indicate a very cautious business that may be missing out on growth opportunities.
On the other hand, in a tough economy, too much debt can cripple your ability to repay your debt.
When interest rates are very low debt can be seductive, almost like an offer of free money.
However, when they go up, unless you have a highly profitable business and excellent cash-flow the interest expense alone can cause severe financial distress.
The way to manage your debt is to create a Forecast that looks at what could happen if rates climb and create scenarios for that possibility.
The other thing to do is to lock your loans into the longest term possible with a fixed rate of interest.
Here are two examples of leverage ratios…
Debt to Equity Ratio
This is a very simple ratio, calculated as follows:
Total liabilities divided by total shareholder’s equity.
A high ratio will indicate a business that is highly debt dependent and may have challenges getting additional loans if the economy is in a recession.
Bankers will look at a low ratio as being favorable to issue new loans. They will see that the shareholders have financed most of the assets.
Another leverage ratio is…
Debt to Asset Ratio
This ratio will indicate the proportion of assets financed by debt.
A ratio of greater than one will be an indicator that most of the assets are financed by debt.
The above two ratios indicate how much your business is at risk of economic downturns and increasing interest rates.
The next ratio will tell you how much profit you have to service your debt…
Debt Service Coverage Ratio
A high debt service coverage ratio tells you how much you have to cover your interest and principal debt payments.
First, you need to determine your EBITDA. This stands for Earnings Before Interest, Taxes, Depreciation and Amortization.
You take your EBITDA and divide it by your total interest and principal payments.
A high ratio here is preferable.
It will indicate that you have a lot of coverage to pay your financial obligations.
In Summary
Bankers will look at your leverage ratios closely to determine if you qualify for new loans.
Overall, the four sets of ratios we covered in these past three weeks tell you a story about your business that just looking at the main five sections will not.
Your profitability ratios will tell you how profitable your business is, and whether you are charging enough for your products and services. It will tell you how efficient you are in managing your business resources to generate a profit.
Your liquidity ratios will inform you of your ability to pay your obligations as they become due.
Your activity ratios will tell you two things:
- How well you are managing your working capital – cash, accounts receivable and inventory.
- How quickly you convert your working capital assets into cash.
Your leverage ratios will tell you and your banker how leveraged you are, and whether you have more than enough to cover your interest and principal payments.
Thanks for reading…