Now that the Small Business Administration Paycheck Protection Program has run out of funds, are you finding yourself still in need of cash? Lenders will compute various financial ratios during the commercial loan application process and then compare them over time or against industry benchmarks. Financial ratios can be a great health check for your business and show you how lenders will gauge your creditworthiness. Let’s look at some of the more common financial ratios used in the underwriting process and see how various components of each can determine your chances of approval.
Profit margins measure the percentage of profit that your company earns for every dollar it gains in sales. This is the most important Income Statement statistic as it directly affects your company’s bottom line—the fewer gross profit dollars, the less money available to pay operating costs. So in a way, profit margin reflects a business’s vulnerability to sudden (and often frequent) increases in routine business costs such as utilities, health insurance, fuel, and taxes. Since profit margin will vary across different industries, it is best tracked against company competitors.
Average days in inventory calculates how much inventory (in days) is on hand. This metric indicates your company’s ability to convert inventory to sales and how fast it can respond to market or product changes. Inventory days should also be measured against competitors, but generally, you want your company to have a low days on hand. High days on hand could indicate shrinking product demand, high price, or poor product promotion.
Average days in receivables reflect the average length of time between credit sales and payment receipts, which is key to maintaining positive liquidity. You want this percentage to be as low as possible as well. For a company with standard 30-day credit terms, an accounts receivables days number in the 30 range would be reasonable. Should the number be more than the terms you offer to your customers, you may have collection problems which could lead to cash flow issues.
The current ratio measures the overall liquidity position of your company by taking your current assets divided by its current liabilities. The higher the ratio, the more liquid your company. This metric is also good to track alongside competitors. However, you never want your ratio to be less than 1:1. That scenario would suggest that your cash, receivables, inventory, etc., would not cover your short-term payables should they immediately become due.
The debt-to-equity ratio indicates the composition of your company’s total capitalization—the balance between money owed versus money or assets owned. Lenders and investors may have conflicting views of the results of this ratio. Generally, creditors prefer a lower ratio to decrease the financial risk of a company to which they are considering loaning money. Some investors prefer a high ratio to realize the return benefits of financial leverage—using borrowed funds to improve profitability. Borrowing effectively is critical to most business growth, but this approach should be made strategically while increasing profits.
The interest coverage ratio measures your company’s ability to service debt payments from operating cash flow (EBITDA). Can your company undertake new financial commitments? You can show the bank your ability with the interest coverage ratio. Lenders love high percentages—it shows your capacity to fulfill the interest payments of the loan you are (hopefully) about to be granted!
See our ATKGers for help securing your commercial loan. We have the knowledge and resources to analyze your financial ratios and provide valuable insight beyond the numbers. We can help you get your financials squared away during the loan application process while maintaining those loan covenants once approved. Our team members have also built solid connections with some of the best bankers in San Antonio to create synergistic relationships where everyone is enthusiastically working together towards helping you achieve your goals.
Ruth Olivares is a Manager at ATKG and is a Certified Public Accountant and Certified Fraud Examiner. She graduated Cum Laude and obtained her bachelor’s and master’s degrees in Accounting from Trinity University. Ruth can be reached at 210.733.6611 or via email at firstname.lastname@example.org.
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