Read Your Financial Statements Like a Banker

This article is a reprint of Wise Bread's contribution to OPEN Forum from American Express -- where small business owners can get advice from experts and share tips with each other.

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Let’s face it — financial statements aren’t the most fascinating things to read. Unless, that is, you’re a banker.

Your balance sheet and income statement tell a banker more about your business than you may think. Whether you’re applying for a new loan, renewing a line of credit, or submitting your financials because your loan agreement requires it, you need to know what goes on in your banker’s head when reading your financial statements.

Fundamentally, a lender cares about three things:

• Performance (including profitability and good management practices)
• Liquidity
• Leverage

A history of strong>profitability together with evidence of sound management practices and good financial controls assure your banker that you’re likely to continue successfully in the years to come. But even profitable businesses find themselves in trouble when their cash flow turns to a trickle, so your liquidity is another of their concerns. As you might guess, your ability to pay your debts, particularly the money you owe them, is also high on their list of worries.

While your banker may eyeball your financial statements when they receive them, they won’t really role up their shirtsleeves until the credit department crunches the numbers. What they’re really waiting for is the ratio analysis. When compared to your historical performance and to that of your peers, ratios tell a lender, at a glance, whether yours is a company they want to do business with. So if you want to read your financial statement like a banker, you need to know which ratios they care about, what they mean, and what values make them happy.

Performance Ratios

These ratios tell the lender how well you use the assets in your business to generate profits and cash flow. Historical trends and comparisons to your peers will help them evaluate the likelihood of your continued success. Be sure to supply your lender with the correct industry code (NAICS) and point out any significant differences between your company and those of your peers.

There are seven primary performance ratios.

Net Profit as a Percent of Revenue (a.k.a. Net Profit Margin)

(Revenue - Pretax Expenses) ÷ Sales

This percentage should be stable or increasing from year to year. Since it's the primary measure of your firm’s profitability, any decline will concern your lender.

Gross Profit as a Percent of Sales (a.k.a. Gross Profit Margin)

(Sales - Cost of Goods Sold) ÷ Sales

This ratio should be stable or increasing from year to year. If it starts to head south, your lender will suspect falling prices or increased expenses.

Operating Expense Ratio

Operating Expenses ÷ Sales

This percentage should be stable or decreasing from year to year. Often, companies ramp up their fixed expenses in anticipation of future growth (particularly salaries, rent, telephone, office expense, advertising, etc.). The problem is if the expected sales never come, come more slowly than anticipated, or actually decline, the extra expenses are tough to shed. Lenders will pay close attention to any trend that indicates a disproportionate growth in your expenses relative to sales.

Accounts Receivable Turnover Ratios

Sales ÷ Accounts Receivable

Accounts receivable turnover indicates how effectively you collect from your customers. If the result of the calculation is equal to 12, you’re collecting your accounts receivable approximately every 30 days (365 days in a year/12). If that number goes down from year to year, or if it exceeds your stated payment terms, it suggests that your credit policies and procedures have deteriorated. Lenders will be concerned that some of what you’re owed may not be collectible.

Inventory Turnover

Cost of Goods Sold ÷ Inventory

Inventory turnover measures a company’s ability to purchase and convert inventory into sales. If the value is equal to 12, then you’re selling, or turning, your inventory approximately every 30 days (365 / 12). If that turnover slows from year to year, or compares unfavorably with your peers, a lender will suspect stale inventory, poor buying practices, or a business slowdown.

Accounts Payable Turnover

Cost of Goods Sold ÷ Accounts Payable

Accounts payable turnover is an indication of how quickly you pay your bills. If Costs Of Goods Sold (COGS, your direct production expenses) are twelve times payables, then you're paying, on average, every thirty days (365/12). This number should be in line with your vendors’ payment terms. If payable turnover is declining from year to year, the lender will wonder why you’re paying more slowly and whether your vendors will stand for it.

Fixed Asset Ratio

Sales ÷ Fixed Assets

The Sales to Fixed Asset ratio provides an indication of how productively you employ your purchased assets (i.e. property and equipment). An increase in this ratio from year to year, or a value lower than industry peers, might signal poor utilization or decision-making. A high ratio might cause a lender to wonder if you’re keeping up with technology, and if not, whether you can continue to compete without investing in new equipment.

Liquidity Ratios

Liquidity ratios evaluate your near term cash requirements (such as for bills and loan payments) relative to your cash and near cash resources (such as receivables and inventory). A cash crunch can be a killer for a growing business, so if your lender spots one on the horizon and you don’t have a line of credit or access to additional capital, they’ll be nervous. Lenders measure liquidity with two balance sheet ratios.

Current Ratio

Current Assets ÷ Current Liabilities

Lenders want to see a ratio of 2:1 or higher. In other words, they want to see twice as much cash coming in within a short period (through collection of accounts receivable or the conversion of inventory into sales) as cash going out (to pay bills, loans, etc.).

Quick Ratio

(Current Assets - Inventory) ÷ Current Liabilities

This ratio should be 1:1 or higher. It’s a more conservative measure of liquidity than the Current Ratio because it recognizes that inventory cannot always be sold quickly.

Leverage / Debt Ratios

Lenders want to know that you are invested in your business and that your cash flow can support your debt. The following ratios evaluate that.

Debt-to-Worth Ratio (a.k.a. debt to equity ratio)

Total Debt ÷ Net Worth

Lenders want to see this ratio at 3:1 or lower. In other words, they want you to finance your assets with at least a dollar of your own funds (or other equity), for every three dollars of borrowed money. If you think about it, it's the same as a home mortgage. A 25% down payment creates a 3:1 debt to equity ratio.

Cash Coverage Ratio

(Net profit + depreciation + non-cash expenses) ÷ Current Maturities of Long Term Debt

The cash coverage ratio provides lenders with a quick read on whether you can make those all-important loan payments. Lenders want this ratio to be at least 1.2 to 1—preferably higher. In other words, they want a comfortable margin between net cash generated by the business and cash needed to cover loan payments. When considering a request for additional debt, they’ll use this ratio to judge whether you will be able to carry the load.

The Bottom Line on Financial Statements

The bottom line is that you, the business owner, need to understand your financial statements. By the way, ratio analysis isn’t just for bankers; it’s a great management tool. When monitored regularly, ratios can help you quickly detect problems in your organization. Successful business owners use ratios—those discussed here, as well as home-grown ones—to simplify the job of management.

Stay tuned for an upcoming post about the lies your financial statements and ratios can tell if you’re not careful to educate your banker.

Do you use ratios to manage your business? Which ones do you find most useful?