How to Read Your Statements: Important Ratios

When you design your financial statements, they should automatically generate some key ratios which you should track relentlessly. Included in these are a few financial ratios which tell you almost all of what you need to know about the financial health of your business.

The key finance ratios are those dealing with
• Leverage
• Coverage
• Operating Loan Margin and
• Profit Margin.

They are applied to the last 12 months performance i.e. a “rolling” year, as if every quarter was a year-end.

Banks Use These Ratios, So Should You

Banks use these as core ratios because they are smart. They give you the most reliable picture of your
• ability to withstand adversity such as a recession of a loss of some major accounts
• ability to pay your bills as they come due and
• profitability.

What is Profit?

There are two main definitions of profit:
• Net income after taxes and
• Earnings before interest, taxes and depreciation and amortization (“EBITDA”).

I think EBITDA is the most useful. More importantly so do the banks. EBITDA is the cash left after all operating costs have been paid. It is the cash available to service the debt you have borrowed, to pay your taxes and to fund the bare-bones capital expenditures needed to keep the lights on.

The Leverage Ratio …

… is the ratio of your debt to your EBITDA.

The higher the ratio, the greater the risk. You won’t be in doubt as to what your bank thinks is reasonable. The maximum will be written right into your loan agreement.

The maximum depends on your type of business. The banks want to keep the ratio inside the level that creates too much risk of trouble for a business like yours.

In your conservative forecast of the future, you never want your debt to more than 75% of the maximum the bank will allow.

The Coverage Ratio

… is the ratio of your EBITDA to the total of your
• interest,
• taxes,
• principal repayments and
• maintenance capital expenditures.

It measures the margin of comfort you have in not only paying your operating costs but all the other items you have to pay to stay in business.
• If it is less than 1:1, you are going out of business.
• If it is more than 1.5X you are building up cash nicely.
• If it is at least 1.2X you are comfortable.

Operating Loan / Loan Value

… is the ratio of your operating loan to the bank valuation of your inventory and receivables in your loan agreement. This value is usually the sum of:
• 25-50% of inventory and
• 50-75% of receivables.

This ratio measures the amount of debt capacity you have used up. Less is better.
• If it is more than 1: 1, you have run out of credit and can expect a call from your bank.
• If it is less than 75%, you have adequate room in your operating line to cover contingencies.

Profit Margin

… is the ratio of your EBITDA to your sales.

Whatever industry you are in, there is a range of profit margins from outstanding to poor. If your ratio is materially lower than these norms, you will have a tougher time getting loans or getting them on the best terms, than those with good margins.

Financial Statements – Why You Need Them, How You Prepare Them

Like an anxious parent, you will constantly check the health of your business. Financial statements will turn you from anxious parent into effective doctor. They will tell you not only if but why your business is healthy or sick. With that knowledge, you can fix a problem or reinforce a strength.

The Foundation of Your Financial Statements – Your “Chart of Accounts “

The emphasis is on the “your”. Good entrepreneurs design their own chart of accounts. They do not leave it to a bookkeeper or accountant.

Each account is a financial record of an important element of your business.
• Revenue accounts track revenues by customer and product or service.
• Expense accounts record expenses by category e.g. wages and rent.
• Asset accounts measure what you have invested in assets used in the business e.g. equipment, supplies, amounts owed by customers.
• Liability accounts record amounts you owe, usually to banks and suppliers.
• Equity accounts track what you and other owners have invested in the business, including profits you have earned but kept in the business.

You Record Every Transaction You Do in Your Chart of Accounts

Each time you sell a product, receive a payment, pay an expense, buy supplies or borrow or repay a loan, you record the transaction in your “Journal” as both
• a “debit” – an increase in an asset or expense account or a decrease in a liability, equity or income account and
• a “credit” – an increase in a liability, equity or revenue account, or a decrease in asset or an expense account.

For example, you will record
• payment of a bill by a customer as a debit to your cash account and a credit to your customer receivables account and
• purchase of a computer as a debit to your equipment account and a credit to your cash account.

At the end of every month, you total all the entries in your Journal that month for each account and “post” the net increase or decrease to the balance for that account at the beginning of the month. The cumulative effect of all the transactions posted from your Journal is reflected in the new balances for these accounts at the end of the month.

Financial Statements Flow Almost Automatically from Your Chart of Accounts

These accounts “feed” your financial statements.
• Your Income or Profit and Loss Statement is created by your revenue and expense accounts for the period.
• Your Cash Flow Statement is created by the changes in your asset, liability and equity accounts during the period.
• Your Balance Sheet is created by the effect of the changes in your asset, liability and equity accounts during the period on the asset, liability and equity account balances at the end of the last period.

Once you design a good chart of accounts, your bookkeeper will do the rest. In the early days in a simple business, you can be your own bookkeeper! All you have to do to understand your business in detail is to read the statements that are produced almost automatically every month by this system.