# THEME: BUSINESS RATIOS & BANK LOANS

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4 a. Return On Investment = Net Income (or Profit) Owner s Equity (5) Profitability Refers to the company s ability to earn an acceptable profit. a. Profit Margin = Net Income (or Profit) Total Revenue QUESTION: What Ratios Should I Use To Determine The Health Of My Business? Let s assume you are thinking about asking your bank for a loan. The first thing you should do is to pull together a financial statement of your business. You are going to use the Liquidity and Leverage ratios to see how things look. The information needed for these ratios can be taken off the following balance sheet: ASSETS: BALANCE SHEET Your Company As of December 31, 20XX Current Assets: Cash \$1000 Accounts Receivable 2000 Inventory 3000 Total Current Assets 6000 Fixed Assets: Equipment 5000 Furniture & Fixtures 7000 Total Fixed Assets Other Assets: Deposits 500 Prepaids 500 Total Other Assets 1000 LIABILITIES: TOTAL ASSETS ===== Current Liabilities: Accounts Payable 500 Notes Payable 2000 Sales Tax Payable 500 Total Current Liabilities 3000 Long-Term Liabilities: Notes Payable 9000 Copyright 2008 John W. Day 4

5 EQUITY: Total Long-Term Liabilities 9000 TOTAL LIABILITIES Owner s Equity 5000 Owner s Draw <1000> Net Profit 2000 Total Equity 6000 TOTAL LIABILITIES & EQUITY ===== Note: Be sure to review the balance sheet so you can see where the numbers come from. The first ratio formula to look at is the Current Ratio, which is also known as the Working Capital Ratio. Total Current Assets or 6000 or 2 Total Current Liabilities This ratio is a rough indication of a company s ability to service its current obligations. Generally, the higher the current ratio, the greater the cushion between current obligations and a company s ability to pay them. A rate of 2:1 is considered satisfactory for most firms. This means you are looking pretty good so far. However, if those Accounts Receivables are old, or the Inventory is obsolete then \$5000 of your \$6000 may not be available to pay off those current liabilities of \$3000. Best to look closer and we do that by using the Quick Ratio which is also known as the Acid Test Ratio. Cash & Equivalents + Trade Receivables or or 1 Total Current Liabilities This ratio is a refinement of the Current Ratio and a more conservative measure of liquidity. This ratio expresses the degree to which a company s current liabilities are covered by the most liquid current assets. A 1:1 value is considered adequate. As long as those Accounts Receivables are current you are still looking good. Might be a good idea to run the Sales/Receivables and Day s Receivable Ratios just to prove to the banker that your receivables are current and collectible. You have demonstrated that the liquidity of the company is satisfactory. Next, you should look at the solvency of your company and you do that by using the Debt to Equity Ratio. Total Liabilities or or 2 Copyright 2008 John W. Day 5

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