By Sandra Taylor-Sawyer: Everybody’s Business
Analyzing financial ratios is a tool business owners can use to grow and sustain the business.
There are many financial ratios that can be used to make management decisions, such as the debt-to-equity (net worth) ratio.
The debt-to-equity ratio will provide business owners with information on whether to add capital or slow growth to allow profits to
reduce liabilities instead of purchasing additional assets.
The balance sheet, which is used to compute the debt-to-equity ratio, is one of the main financial statements that should be prepared and reviewed on a monthly basis. The balance sheet lists total debt or liabilities (money owed to others) of a business. The net worth, or equity of a business, is also listed on the balance sheet; which is the difference between assets (items the business owns) and total debt (liabilities).
The computation for the debt to equity ratio is to divide total debt by net worth. For example, if the results yield 4 (Total Debt $400,000/ Net Worth $100,000), it denotes for every $1 the owner has contributed to the business, creditors contributed $4 (4:1).
Performing the calculation is not as important as what to do after the results are known.
The first thing is to determine if the ratio computed is comparable to other businesses in the same industry. The second is to review plans for the future. If those plans include obtaining a loan, in this example the ratio could make it difficult to obtain financial backing.
The next step is to determine if the 4:1 ratio has changed from the last reporting period. If the ratio is the same as last month or last year, it can be interpreted as the business not paying off its debts. After examining what took place between the two reporting periods, it may also represent some debt was paid off and new debt replaced it. The latter is acceptable; however, if the former reason is true, it can lead to creditors calling notes and not extending credit in the future.
If the ratio is lower than in previous reporting periods, it may be a positive indicator. A lower ratio may represent debt is being paid. However, it is wise to analysis other aspects of the business to determine if sufficient cash is generated from sales to cover expenses and pay off debt.
If the debt-to-equity ratio is higher than previous reporting periods, it is immediately a red flag and should be evaluated.
Financial analysis using financial ratios are an instrumental management tool for any business owner. The results should be used along with other management tools to plan for successful future growth of the business.
Sandra Taylor-Sawyer is director of the Small Business Development Center at Clovis Community College. Call the center at 769-4136 or visit www.nmsbdc.org/clovis.