Has this thought ever haunted you: “What if one of my big customers goes under?” And, have you ever felt out of control when having such worrisome thoughts? Well, you don’t have to sit back and wait for something to happen. You can be proactive.
There is a way by which you can protect yourself against such eventualities. There are key financial tools that, if used on an ongoing basis, will forewarn you of potential financial troubles with your customers.
Let’s take a look at these tools. Their purpose is to assure you that your customers have the financial wherewithal to meet their commitments to you. We will be concentrating more on the target company’s balance sheet because, in the short run at least, a strong balance sheet is no small assurance that the company can meet its financial obligations and will be in business for a while.
Debt to Equity Ratio
This ratio looks at how much of the business is financed by debt and how much was financed through equity. Let’s see how this works.
Suppose that your target company has US$1 million in debt and $1 million in equity. This represents a debt to equity ratio of 1:1 — a good ratio in that the company has leveraged the investment of its owners by 100 percent. In other words, for every dollar that the owners invested in the company, creditors have lent one dollar.
Most bankers have credit guidelines whereby they will not lend to a company that has a debt to equity ratio of more than 2:1. So, in the business mentioned above, if the company has a debt to equity ratio of 2:1, this would mean that creditors are owed $2 million (debt), whereas the investors have put in $1 million (equity). Some lenders regard this as the upper limit of small business loans.
This ratio represents a relationship of the current assets of a business to its current liabilities. It gives you some indication of a company’s viability in the short run. Note that current assets are defined as cash or other assets that will be turned into cash (or cash equivalents) within one year. Current liabilities are defined as liabilities that must be extinguished within one year.
Here’s an example. Suppose that a company’s current assets were $500,000 and its current liabilities were $250,000. Its current ratio would be 2:1 (twice as many current assets as current liabilities). This is a decent ratio in that it has twice the current assets on hand to pay off its current liabilities — a good cushion and one that has been the hallmark of financially sound companies for years.
Let’s look at another hypothetical company. This one has $250,000 in current assets and $250,000 in current liabilities. Its current ratio is 1:1 — not really very comforting in that there is no cushion here for the company to fall back on. In other words, if some of its current assets fail to be converted into cash or cash equivalents within one year, and its current liabilities remain at the same level or higher, the company will become unable to pay its debt as it comes due, without having to attempt to borrow or obtain another type of capital infusion.
Debt Coverage Ratio
This ratio shows how well a company’s cash flow covers short-term debt and how much additional debt a company can take on. Here’s the formula: Net Profit, plus non-cash expenses, divided by debt, equals debt coverage ratio.
You would compute this ratio by looking at a company’s net income and adding back non-cash expenses such as depreciation and amortization. Then you would divide it by the company’s short term debt (due and payable within one year).
A word of caution: A company might have sizable long-term debt, of which only a small amount is due during the course of one year. It’s sort of like your mortgage where you are not expected to pay off the balance within one year, but are expected to pay only the year’s amortization of principal.
Therefore, be sure to use as the denominator the total debt that is due within one year. Just go to the company’s balance sheet and take the figure under current liabilities. This represents the amount that is due within one year.
Here’s an example of how the numbers work. If your target company has net income plus non-cash expenses of $1 million and current liabilities of $500,000, then it would have a debt coverage ratio of 2:1. In other words, it has twice the annual net income to pay off its short-term debt.
Is this a good ratio? Ideally, your customer should not have a ratio of less than 2:1. In other words, the business should be generating enough income to be able to pay its current liabilities twice. This gives the company a good cushion for any unforeseen eventualities.
Other Reporting Agencies
If the company in question is publicly traded, the financial data that you need to make the above simple, but important, computations are easy to retrieve. If it is a privately held company, there are other reporting agencies to which you can look for data. Also, you can ask your customer for some financial information? You certainly have a vested interest in that data.
You’ve got to spend the small amount of time to compute these ratios for any company that is causing you concern.
I would say that, in most cases, computing the ratios annually will suffice. But, if you are really concerned about a customer or supplier, you should move make the computations semi-annually or even quarterly.
Using the financial tools mentioned above can make your life simpler if you make use of them. They can be your watchdog against weak or weakening customers or suppliers. Use them often, and good luck!
Theodore F. di Stefano is a managing partner at Capital Source Partners and can be contacted at email@example.com.