Financial Ratios and

Bank Financing

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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

Earnings per Share

(common shares)

(Net Income Preferred

Dividends) Number of
Common Shares
Outstanding

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)

Classification
Capital-Market Ratio

Capital-Market Ratio

Price-Earnings Ratio

Market Price per share

Earnings per share

Capital-Market Ratio

Dividend Payout Ratio

Dividends per share

earnings per share

Capital-Market Ratio

Dividend Yield Ratio

Dividends per share

Market Price per share

Capital-Market Ratio

Return on Total Assets

Net Income + [Interest

Expense x (1-tax rate)]
Average total assets

Return on Common
Shareholders Equity

(Net Income Preferred

Dividends) Average
common shareholders
equity.

Book Value Per Share

Common shareholders
equity number of common
shares outstanding

Profitability Ratio

Profitability Ratio

Capital-Market Ratio

Significance
Tends to have an effect on
the market price per share,
as reflected in the priceearnings ratio.
Shows the potential effect
on earnings per share of
converting convertible
securities into common
shares.

An index of whether a share

is relatively cheap or
relatively expensive and a
measure of investor
confidence.
An index showing whether a
company pays out most of
its earnings in dividends or
reinvests the earnings
internally.
Shows the dividend return
being provided by a share,
which can be compared to
the return being provided by
other shares.
Measure of how well assets
have been employed by
management.
When compared to the
return on total assets,
measures the extent to
which financial leverage is
being employed for or
against common
shareholders.
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
Working Capital

Current Ratio

Acid-Test (Quick) Ratio

Formula
Current Assets Current
Liabilities

Current Assets Current

Liabilities
(Cash + Marketable
Securities + Current
Receivables) Current
Liabilities

Classification
Liquidity Ratio

Liquidity Ratio

Liquidity Ratio

Significance
Represents current assets
financed from long-term
capital sources that do not
require near-term
repayment
Test of short term debtpaying ability
Test of short-term debt
paying ability without having
to rely on inventory.

Measure of how many times

a companys accounts
receivable have been
turned into cash during the
year

Accounts Receivable
Turnover

Sales on account Average

accounts receivable
balance

Turnover Ratio

Average Collection Period

(age of receivables)

365 days Accounts

Receivable turnover

Turnover Ratio

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

Debt to Equity Ratio

Total Liabilities
Shareholders Equity

Leverage-Capital-Structure
Ratio

Net Profit Margin

Net Income Sales

Profitability Ratio

Measure of the average

number of days taken to
collect an accounts
receivable.

Measure of the likelihood

that creditors will continue
to receive their interest
payments.
Measure of the amount of
assets being provided by
creditors for each dollar of
assets being provided by
the shareholders.
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

(Cash + Marketable
Securities + Current
Receivables)
Current Liabilities

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

0.47

Poor, cash cannot

satisfy obligations

Accounts
Receivable 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
receivables)

365 days Accounts

Receivable turnover

365 11.02

33.12

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

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

3.99

Acid-Test (Quick)
Ratio

Times Interest
Earned

Earnings before
interest expense and
income taxes
interest expense

Very good, receivables

rarely extend beyond
terms

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)

Current ratio becomes: 0.88
Quick ratio becomes: 0.53

-fair
-fair
-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)

Current ratio becomes: 0.95
Quick ratio becomes: 0.58
Net earnings will have increased

- fair /good
-good
-poor
-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.

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