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Analyzing Business Financials (part 1)

If you’re holding a note secured by a business and are looking to sell, one of the things a potential buyer will consider is the financial health of the business. There are lots of measures for this, but here is a rundown of some of the key ratios used.

Current Ratio.  The current ratio is, simply, total current assets divided by total current liabilities.  Current assets and liabilities are those that are immediately liquid, or have a term of less than one year.  If this ratio is less than 1, it suggests that the business does not have enough assets to pay off its immediate liabilities.

Quick Ratio.  This is much like current ratio, but this formula divides quick assets (current assets less inventory) by current liabilities.  The quick ratio takes away the effects of inventory that might make the current ratio look better than it should, since inventories are not immediately liquid.

Accounts Receivable Turnover Ratio.  Take accounts receivable at the beginning of the period plus accounts receivable at the end of the period and divide by 2.  That’s Average Accounts Receivable.  Then divide Sales by Average Accounts Receivable.  This gives you some indication of how current the business’ receivables are, and how reliable the customers are for making payments.

Return on Assets.  This is a measure of how well management is using its assets to make a profit.  Divide Net Income by Average Total Assets (beginning assets plus ending assets divided by 2).  The higher the number, the better job management is doing of employing existing assets.

Return on Equity.  Divide Net Income by Average Shareholders’ Equity.  The higher this ratio, the better the company is doing to maximize the shareholders’ return on their investments.

Operating Cash Flow to Sales.  Using the Statement of Cash Flows, divide net cash provided by operating activities to Sales for the year.  The higher this ratio, the better job management is doing at turning sales into cash.  If this ratio is low, even when sales are increasing, it can indicate that management is doing a poor job of collecting on receivables, extending too much credit, or, worst of all, recording fraudulent sales.

Cash Flow Coverage.  Again using the Statement of Cash Flows, divide Net Cash Provided by Operating Activities by Capital Expenditures (expenditures for property, plant, and equipment) OR by short-term debt expenses. The higher either of these ratios, the better the company’s ability to meet its various obligations with cash on hand.

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