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Herbein + Company, Inc.

Energy

Herbein Blog

19 Sep
2013

Is Your Business Financially Strong?

Is Your Business Financially Strong?

September Energy Advisor

Running a business is challenging. In addition to client demands, staffing issues, compliance standards and product quality, you must be sure that your business is financially sound. Financial ratios are tools used by business owners, finance managers, bank analysts, etc. to evaluate the financial strength of a business. These ratios are often used from a historical perspective to establish trends for the business or in conjunction with industry data to evaluate the business in comparison to its competitors. The ratios can help identify strengths, weaknesses or potential problems and serve as a tool in making business decisions.

There are a number of financial ratios that are used to analyze the financial health of a business and below are three key ratios commonly used.

Current Ratio
Current Ratio is a liquidity ratio that is an indication of the ability to timely pay current liabilities (debts due within one year) and is a measurement of the solvency of the business. It is a barometer of a business’ ability to weather an economic downturn. It is calculated as follows:

Current Ratio =     Total current assets    
Total current liabilities

Example: $2,500,000 current assets/$800,000 current liabilities = 3.13 current ratio

In this example there is $3.13 of currents assets for each $1.00 of current liabilities.  A current ratio of 2.0 or greater is normally considered and indication of a strong liquidity position.  A low current ratio may indicate stress on a business to pay its accounts payable on a timely basis.  Conversely, a very high current ratio may indicate there are assets that could be better utilized. 

Debt to Equity Ratio
Debt to equity ratio is a leverage ratio that is an indication of whether a business is properly capitalized or leveraged.  It is calculated as follows:

Debt to Equity Ratio =    Total debt                  
Stockholder Equity

Example: $1,100,000 total debt/$900,000 stockholder equity = 1.22 debt to equity ratio

In this example there is $1.22 of debt for each $1.00 of invested capital.  A debt to equity ratio of 2.0 or lower is normally considered as an indication of an acceptable capitalization/leverage position.  A higher ratio may indicate that a business is too highly leveraged and thereby a cause of concern for creditors.  As such, it could inhibit the ability to secure additional financing.

Fixed Charge Coverage Ratio
Fixed Charge Coverage ratio is a coverage ratio that is an indication of whether the operation of a business is generating sufficient cash flow to service the required payments on its term debt. It is calculated as follows:

Fixed Charge Coverage Ratio =
Earnings before interest, taxes, depreciation and amortization
Annual principal and interest payments

Example: $500,000 EBITDA/$450,000 debt service = 1.11 fixed charge coverage ratio

In this example the cash flow generated from the business operations is $1.11 for every $1.00 of debt service requirement.  Lenders often focus on this ratio in consideration of the ability to repay existing or potential new debt.  They normally require a ratio in the range of 1.10 to 1.25.

Financial ratios are benchmarks and those benchmarks may vary among different industries.

For more information visit us on our website at www.herbein.com, or contact the author Aaron M. Shahan at amshahan@herbein.com.

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