Small Business Series – Mistake 7B:
In the last edition, we continued our series of common mistakes that small businesses make, by looking at the value of preparing financial forecasts/projections and the dangers of not using them. This edition will expand on that topic by focusing on how financial ratios and metrics (R&M) can be utilized throughout that process. Due to the wide array of operational ratios and metrics available to businesses across multiple industries, we will focus on the most common balance sheet centered R&Ms; the insights they provide and ways they can be managed. Many more ratios are also available here.
Tangible Net Worth (TNW)
What do they measure? Total tangible assets less the liabilities of a company. Insights: This is a simple, down to earth method of determining the value of a company. Having a high TNW can increase the level to which a creditor is willing to extend. Determining a healthy TNW can be difficult to determine, due to the number of variables at play. Too little TNW can quickly result in a cash flow shortage. Too much TNW can be an indication of poorly utilized resources. Management Tools: Setting a target TNW can be very beneficial to a company as they make decisions. Coupling a target TNW with forecasted/projected statements of income and balance sheets can be a valuable tool in setting appropriate equity distribution and contribution expectations. As time goes on, a business can adjust the target based on what they find to be a proper amount. Setting a target can also help determine if a different direction needs to be taken as alternatives are evaluated.
Leverage/Debt to Equity ratios
What do they measure? The debt level of a business in comparison to its equity. Insights: These ratios can serve two very critical roles. First, they can help make sure adequate levels of equity are kept in the business to cover the debt load. Second, they can help make sure debt levels are not increasing to an unsustainable level. Creditors feel their level of risk increasing as this ratio increases and will often times have covenants in place to keep these ratios at an appropriate level. A healthy ratio should provide adequate cash availability, while also showing creditors a low risk proposition. It is critical to keep these ratios in consideration as forecasts/projections are prepared. Rapid revenue and balance sheet growth can be tantalizing due to the profits they potentially offer but can put a business in serious risk if the balance sheet growth is out of proportion with the profits experienced. Additionally, if there is a start-up phase to a project, rapid balance sheet growth could be coupled with losses, which would only magnify the disproportion. Utilizing the ratios through forecasts/projections helps determine how much the balance sheet can grow while staying healthy. They can ensure adequate cash will be available for the growth and that creditors can maintain their desired position through the process. Management tools: If individual debt is present as a liability, this could be subordinated to a creditor. At that time, the creditor will likely allow it to be removed as a liability and added as equity for purposes of the calculation. This can strengthen the ratio, but does put the subordinated debt holder at a much higher risk and may limit the potential for the debt to be paid at a time in the future. Determining what an appropriate ratio is can be predicated on the type of debt in place. Some debt is much lower risk than others. Proving to a potential creditor that certain debt is low risk can potential increase the appetite for a higher ratio. For instance, if a supplier will guaranty that it will accept returns and forgive debt by the return, a creditor knows they would have an outlet for that debt in liquidation and their risk is reduced.
What do they measure? The liquidity of a company, its ability to meet current obligations with resources currently available to them. They are a function of working capital. Insights: Liquidity ratios that are out of balance can be a first indication that cash shortages might be coming. Businesses should keep their historical receivable collection trends in mind when determining a healthy liquidity ratio. Proper and timely allowances and write-offs to receivables are critical in making sure the ratio is credible. Internal users can use this information to project cash flow. External users, such as bonding agents for construction companies, use this information to determine the amount they are willing to bond. Management tools: Businesses should keep close eye on debt moving towards being current, doing whatever they can to move keep the debt as long-term if they are able to and if it is needed.
Debt Service/Fixed Charge Coverage (DS/FCC)
What do they measure? The ability for EBITDA to cover debt principal and interest payments. Insights: It is a good practice to measure EBITDA internally, but oftentimes this process is only done to track how it is trending for purposes of forecasting what an end of year DS/FCC ratio might look like. Banks will frequently use a DS/FCC ratio as a covenant. Management tools: Having a strong EBITDA is the best way to ensure an adequate DS/FCC. However, if you find EBITDA may be coming in lower than wanted or expecting, there are some manageable pieces to the equation. Typically, the principal portion of the equation is based on principal payments paid during the year, principal payments paid in kind during the year, or principal payments scheduled to be made in the upcoming year. Management can come into play by proactively seeking to extend principal payments where able. If principal payments are the key denominator, there can be a little more procrastination than if principal payments paid in kind or scheduled future year payments are the key denominator.
With a diverse landscape of how businesses are structured, operated, and cash flowed, it can be difficult for them to determine healthy ratio or metric goals for their specific set of circumstances. Due to the wide variety of clients that CPAs serve, they are a great resource for helping to develop healthy and attainable goals.
R&Ms when applied to forecasts/projects are a very powerful tool. If done well, tremendous amounts of time can be saved in the future by proactively planning. Additionally, profits and cash can be maximized by using these R&Ms to help make decisions. Identification of problems before they happen allows for many problems to be extinguished before they even happen. Internal and external accountants alike should be looking for ways to utilize ratios and metrics. They are not likely to regret doing so.
See previous installments in the Small Business Mistakes Series:
- Confusing Knowing Trade with Knowing a Business
- Forgetting ‘Achievable’ When Setting SMART Goals for a Small Business
- Failure to Implement Proper Capitalization Planning & Equity Retention in Your Business
- Failing to Price or Buy Appropriately
- Ignoring GAAP or Tax Effects of Business Decisions
- Avoiding Difficult Decisions in Your Business
- Not Using Forecasts or Projections – Part A
By Ben Ritenour, CPA, Manager
This installment is brought to you by Ben Ritenour. Ben is a Manger in the firm’s Assurance Division. Not only does he oversee compilation and review engagements, but his first-hand experience in private industry allows him to perform various consultative services for the firm’s clients, including outsourced CFO services and bank examination procedures.
Ben is both a member of the American Institute of Certified Public Accountants (AICPA) and was recognized as ’40 Under 40′ within the Pennsylvania Institute of Certified Public Accountants (PICPA.)
Connect with Ben on LinkedIn or contact our office to get in touch.