A brand new business owner may not necessarily be found as a financial expert. It is quite common and natural that a start-up is often required to take a loan. Investors normally wish to be provided with an extensive financial analysis and data before considering 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 calculate all of the company’s financial ratios. These ratios define a business’s health, well-being, and risks. Investors are highly interested in seeing these facts and figures before deciding whether to invest in a certain business.
Ratio analysis is one of the most recognized methods for determining a business’s financial condition. These ratios are also found to be most helpful in making comparisons and assessments between clients and other companies in the industry.
In accounting and bookkeeping, each of the ratios below is extremely important for credit professionals to make informed decisions. They can judge and decide whether to give credit to customers, exactly how creditworthy the business is, how much to invest, and what the appropriate terms of sale should be. Here are the financial ratios lenders review when deciding a business’s creditworthiness.
Debt-to-Equity Ratio
The debt-to-equity ratio permits lenders to compare a company’s assets with its debts. A lender considers a business a high risk when their debt to equity ratio is high. They would much rather invest in a company where the ratio calculated is found to be of little or no debt.
To calculate the debt-to-equity ratio:
- Take a company’s recent balance sheet.
- Divide the total liabilities by their total figure of shareholder’s equity.
- Take, for 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.
Operating Margin
An operating margin calculates a company’s profit as a percentage of its total sales. Operating margins find a company’s total revenue and total profit. These figures give a clear picture of the company’s efficiency.
To find a company’s operating margin, divide the income from operations by the total net revenues. For example, a company with $1 million to $100 million in yearly profits from sales will have its operating margin calculated at 1%.
Current Ratio
The current ratio is used as a liquidity ratio. It is calculated when the total sum of all current assets is divided by total liabilities. This ratio measures whether 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 many current assets as current liabilities.
This ratio is similar to the debt-to-equity ratio, though in this case, total assets are divided by total liabilities instead of liabilities divided by shareholder’s equity.
Inventory Ratio
The inventory ratio can be used to calculate a company’s production and purchasing efficiency. It gives a fair picture of how many times the company is able to sell its inventory over a specific period of time.
To calculate this ratio, divide the entire cost of the services or products sold by the entire inventory cost. If the ratio is higher, the company is more efficient at turning over its inventory. Lenders will consider such businesses creditworthy and most likely to be successful and productive for investment.
Let’s take an example. If a business has sales of $500,000 and inventory of $100,000, the inventory ratio calculated will be 5-to-1.
Conclusion
In conclusion, understanding key financial ratios is crucial for start-ups seeking loans. Investors rely on these ratios to assess a business’s health and potential and make informed investment decisions. From debt-to-equity to inventory turnover, each ratio offers insights into a company’s financial viability and helps pave the way for successful funding and growth.
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