Most startups fail due to financial problems. Potential investors are well aware of this.
Just as a ship’s captain watches the deck for signs of danger, a business owner should look to several financial metrics to determine if the business is going aground. These metrics are used to measure and assess the status quo, and we address a few key metrics in this document.
By using these tools, suboptimal outcomes can be anticipated and possibly avoided.
A Review of Assets and Liabilities
Balance sheets categorize a company’s assets as either current assets or long-term assets. The current assets are expected to benefit the company within the next year. Long-term assets provide value for more than one year.
An example of a current asset might be a six-month certificate of deposit. A long-term asset can be a machine that is expected to operate for many years.
A company typically has several assets on its balance sheet in addition to cash. The company may invest its cash in financial instruments such as money market accounts, certificates of deposit or US Treasury bills. Because these investments can be quickly converted into money, they are considered cash equivalents in general accounting. Cash and cash equivalents are classified as current assets.
Likewise, a company has short-term liabilities and long-term liabilities. Current liabilities are those that will fall due within the next year. Long-term liabilities are those that are paid off over many years.
return on investment
A common metric of a company is return on assets (ROA). Return on Assets helps the prospective investor gain insight into how profitably a company is using its assets.
If Company A has a 9% ROA while Company B has a 23% ROA, we see that Company B is making a lot more return on its assets. The higher ROA could indicate a competitive advantage that makes Company B an attractive investment. Conversely, if you are the owner of Company A, you might do well to investigate how your competition is making more profit per dollar of assets.
The ROA formula is:
ROA = Net Income / Average Total Assets
Net income can be easily found on a company’s income statement. Average Total Assets is calculated by adding the value of Total Assets at the beginning of the year to the value of Total Assets at the end of the year. Divide this sum by two.
The more debt a company takes on, the more likely it is that the company will not be able to pay that debt. Leverage shows the proportion of assets financed with liabilities. The formula for the debt ratio is:
Debt Ratio = Total Liabilities / Total Assets
As of spring 2017, Exxon Mobile had a debt ratio of 49% (162,989.00/330,314.00). The other 51% is funded by the company’s shareholders. For comparison, BP has a debt ratio of 64%. If an economic downturn hits and there are fewer sales, which of these companies will be more likely to default on its debt?
More immediate are a company’s current liabilities: obligations that must be paid within the next year. The current ratio gives investors a glimpse of the company’s ability to service its short-term debt. For this we use the following formula:
Current Ratio = Total Current Assets / Total Current Liabilities
The higher the ratio, the stronger the financial situation. Using hardwood flooring outlet company Lumber Liquidators, we get a current ratio of 8.86. This ratio shows that for every $1.00 of current debt that Lumber Liquidators has to pay off over the next year, Lumber Liquidators has $8.86 on hand!
On the other hand, American Airlines has a current ratio of 0.76 as of this writing, meaning the company owes just seventy-six cents for every dollar it has to pay back over the next year. One company is clearly struggling more than the other to pay its bills.
The Acid Test Ratio (i.e. Quick Ratio)
The Acid Test Ratio is a refined version of the current ratio. All working capital, used at the current ratio, is not always easily convertible to cash (should the company need to quickly repay debt). Significantly, inventory is excluded from the proving ground. The formula is:
Endurance test = Cash & Equivalents + Market. Securities + Accounts Receivables / Total Current Liabilities
If we reexamine Lumber Liquidators using the acid test ratio, we get a value of 0.22 – a much weaker result than the current ratio. There are several interesting implications here. Lumber Liquidators is a company whose current value comes primarily from its inventory. It has relatively little cash on hand. The savvy investor can take this information and try to envision situations in which a stocked company might suffer, and then estimate how likely those episodes might occur.
American Airlines, whose working capital relies less on inventories and more on cash and accounts receivable, has an endurance test ratio of 0.90.
Cash is the lifeblood of business. Even when sales are good, business owners are often looking for additional cash to grow the business – either from debt or equity. The information in the balance sheet, income statement, and cash flow statements are critical for outside investors to decide whether to commit that money to the company. The metrics presented here provide operational insight not only to potential investors but also to current business owners.