Most startups fail due to financial problems. Potential investors are well aware of this.
Just as a ship’s captain posts lookouts on deck for signs of distress, an entrepreneur must use various financial ratios to determine if the business is about to run aground. These indices exist to measure and judge the status quo, and we review some key indices in this paper.
By using these instruments, suboptimal results can be predicted and perhaps avoided.
A review of assets and liabilities
Balance sheets classify a company’s assets as current assets or long-term assets. Current assets are expected to provide a benefit to the business within the next year. Long-term assets provide a benefit for more than one year.
An example of a current asset might be a certificate of deposit with a maturity of six months. A long-term asset could be a machine that is expected to run for many years.
A company typically has several assets other than cash on its balance sheet. The company may invest its cash in financial instruments such as money market accounts, certificates of deposit, or US Treasury notes. Because these investments can be quickly converted to money, general accounting practices consider them to be cash equivalents. Cash and cash equivalents are considered current assets.
Similarly, a business has current liabilities and long-term liabilities. Current liabilities are those that are due within the next year. Long-term liabilities are those that will be paid off over the course of many years.
return on assets
A common measure of a business is return on assets (ROA). Return on assets helps the potential investor gain insight into the profitability of a company using its assets.
If Company A shows an ROA of 9% while Company B shows an ROA of 23%, we see that Company B is getting much more return on its assets. Higher ROA could indicate a competitive advantage that makes Company B an attractive investment. Conversely, if you are the owner of Company A, you may do well to examine how your competition is producing more earnings per dollar of assets.
The ROA formula is:
ROA = Net Income / Average Total Assets
Net income can be easily found on a company’s income statement. Average total assets are calculated by adding the value of total assets at the beginning of the year with the value of total assets at the end of the year. Divide that sum by two.
debt ratio
The more debt a company takes on, the more likely it is that the company will be unable to pay that debt. The debt ratio shows the percentage of assets that are financed by liabilities. The formula for the debt ratio is:
Debt Ratio = Total Liabilities / Total Assets
In spring 2017, Exxon Mobile had a debt ratio of 49% (162,989.00/330,314.00). The other 51% is financed by the company’s shareholders. By comparison, BP has a debt ratio of 64%. If an economic downturn occurs and there are fewer sales, which of these companies is most likely to default on its debts?
current radius
More immediate are the current liabilities that a company has: obligations that must be paid within the next year. The current ratio gives investors an idea of the company’s ability to pay its liabilities in the short term. To do this, we use the following formula:
Current Ratio = Total Current Assets / Total Current Liabilities
The higher the relationship, the stronger the financial status. Using the hardwood flooring company Lumber Liquidators, we get a current ratio of 8.86. This ratio reveals that for every $1.00 of current debt that Lumber Liquidators must pay in the coming year, they have $8.86 available!
On the other hand, at the time of writing, American Airlines has a current ratio of 0.76, which means that the company has just seventy-six cents for every dollar of debt it must pay off in the coming year. One business clearly struggles more than the other to pay its bills.
The acid test ratio (i.e. the quick ratio)
The acid test ratio is a more refined version of the current ratio. Total current assets used in the current ratio are not always easily convertible to cash (should the business need to pay off debt quickly). Significantly, inventory is excluded when the acid test is used. The formula is:
Acid test = Cash and equivalents + Market. Values + Accounts. Admissible Current Liabilities / Total
When we retest Lumber Liquidators with the acid test ratio, we get a value of 0.22, a much weaker sample than its current ratio. There are several interesting implications here. Lumber Liquidators is a company whose current value comes primarily from its inventory. You have relatively little cash on hand. The astute investor can take this information and try to imagine situations in which a company with a lot of inventory might suffer, and then estimate the probability of such episodes occurring.
American Airlines, whose current assets depend less on inventory and more on cash and accounts receivable, has an acid test ratio of 0.90.
conclusion
Cash is the lifeblood of the business. Even when sales are good, business owners often look for additional cash resources to grow the business, be it debt or equity. The information presented in the balance sheet, income statement, and cash flow statements are vital for outside investors to decide whether to provision that money for the business. The indices presented here provide operational information not only for potential investors but also for current business owners.
