A brand new business owner may not necessarily be found as a financial expert. It is quite common and natural that a start-up will often be required to take a loan. Investors normally wish to be provided with an extensive financial analysis and data before they consider granting any such loan to the owner for their start-up.
So, what is this data and where does it come from? The data is from the bookkeeping records that calculates all of the company’s financial ratios. These ratios define the health and well being of a business along with the risks. Investors are highly interested to see these facts and figures before deciding if they wish to invest in that certain business or not.
Ratio analysis is one of the most recognized methods used for determination of a business’s overall financial condition. These ratios are also found to be most useful in making comparisons and assessments between a client and other companies found in the industry.
In the field of accounting and bookkeeping, each and every one of the below ratios are extremely important for credit professionals to make informed decisions. They are able to judge and decide if they should or shouldn’t give credit to customers, exactly how credit worthy the business is, how much they should invest, and what the appropriate terms of sale should be.
Financial Ratios That Lenders Review when Deciding the Credit Worthiness of a Business
The debt-to-equity ratio permits lenders to compare a company’s assets with its debts. A lender considers a business as a high risk when their debt to equity is a high ratio. They would much rather invest in a business where the ratio calculated is found to be of little or no debt.
In order to calculate the debt-to-equity ratio, take a company’s recent balance sheet. Divide the figure of total liabilities by their total figure of shareholder’s equity. Take an example, a business with a figure of $200,000 as liabilities and a figure of $400,000 as assets. That company’s debt-to-equity ratio will be calculated as 0.5.
An operating margin is used to calculate a company’s profit as a percentage of their total sales. Operating margins find a company’s total revenue and total profit. These figures give a clear picture of where the company is standing in terms of efficiency.
In order to find out the operating margin of a company, divide the income from operations by the total figure of net revenues. Take an example, a company with a figure of $1 million from $100 million yearly profits from their sales, will have their operating margin calculated at 1%.
Current ratio is used as a liquidity ratio. This ratio is calculated when the total sum of all current assets is divided by the total current liabilities. This ratio measures if you have sufficient assets to pay for your liabilities. If your current ratio is calculated to be two, it means that you have twice as much current assets as your current liabilities.
This ratio is similar to the ratio of debt-to-equity, though in this case, total assets are divided by total liabilities instead of liabilities divided by shareholder’s equity.
A company’s production and purchasing efficiency can be calculated by using the inventory ratio. The inventory ratio gives a fair picture of how many times the company is able to sell their inventory for a specific period of time.
In order to calculate this ratio, divide the entire cost of the services or products sold with the entire inventory cost. If the ratio is higher, it means the company is more efficient at turning over their inventory. Lenders will take and consider such businesses as credit worthy and most likely to be successful and productive for investment.
Let’s take an example for this. If a business has sales of $500,000 and inventory of $100,000, the inventory ratio calculated will be 5-to-1.
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