When a business is looking to benchmark their performance and develop key performance indicators for growth, consider taking the perspective of a lender.
Smart lenders look closely at the financial performance of a business, so you might ask the question: “Would my company receive the credit it needs to grow?” Encouraging businesspeople to answer this question—even if they don’t need a loan—helps to identify weaknesses and make improvements.
Many private companies find it challenging to access financial resources for growth when lenders are cautious and facing pressure to avoid risky loans. In addition to improving cash levels and earnings, cutting expenses, and reducing debt, companies seeking credit should consider focusing on improving key financial metrics that can best predict default.
The five financial statement ratios that are related to default analysis and are often used by creditors to assess the company’s financial performance include:
- Cash to assets
- EBITDA to assets
- Debt service coverage ratio
- Liabilities to assets
- Net income to sales
Improving these key financial metrics can enhance your appeal to banks and other potential creditors.
At Sageworks, we asked some of our very own experts—Michael W. McNeilly, director of advisory services, and Libby Bierman, analyst—for their advice on improving these metrics. If you’d like to learn more about financial metrics, check out the Sageworks Profitcents blog.
The 5 financial metrics you should be improving
1. Cash-assets ratio
The cash-assets ratio is a key measure of liquidity and one of several coverage ratios that tell creditors about a company’s likelihood of default. According to Lawrence Litowitz, a partner at strategic advisory firm The SCA Group LLC, it provides an indication of how much flexibility a firm has to utilize cash or to access liquid accounts in order to make good investments.
A company with its cash tied up in accounts receivable and inventory (a low ratio of cash-assets) might not have enough cash to keep the lights on, much less to ramp up production if sales accelerate. “Every entrepreneur will tell you cash is king,” notes M. Cary Collins, director of the Global Entrepreneurship Program and associate professor of finance at Bryant University.
How to improve your cash-assets ratio
A key way to boost a business’s cash-assets ratio is to boost its cash position, and there are numerous approaches to do this.
One way to boost a firm’s cash position is by lowering accounts receivable: This can start with an examination of the company’s credit policy to make sure its credit practices are actually increasing the business’s revenue and income rather than simply draining its cash. Some businesses extend different credit terms to different customers based on creditworthiness and the overall relationship involved, according to McNeilly.
Accounts payable is another line in the financial statement that can provide opportunities for improving this ratio. Avoid pre-paying expenses or paying bills earlier than the terms agreed upon so that the funds are kept inside the business (and perhaps earning interest) as long as possible.
Another way to ensure the cash-assets ratio is as high as possible is to carefully manage inventory. Utilize a system that allows the business to order only when needed so that cash is not tied up in merchandise. “Take a look at your inventory and sell your slow-moving items,” advises Litowitz.
In short—improve your cash-assets ratio by:
- Lowering accounts receivable and limiting on-credit purchases
- Monitoring invoicing procedures to limit late collections
- Avoiding pre-paying expenses
- Selling off slow-moving inventory
2. EBITDA-assets ratio
EBITDA, or earnings before interest, taxes, depreciation, and amortization, is often used to measure a firm’s ability to generate income, and is widely used as a substitute for pre-interest, pre-tax cash flow from operations.
Comparing EBITDA to a company’s assets helps show efficiency—how much income, or cash, a company can generate from its equipment, property, and other assets.
How to improve your EBITDA-assets ratio
Focus on the numerator: Boosting EBITDA typically involves either raising revenues (without a commensurate increase in expenses) or cutting expenses.
Raising revenues can involve better planning, or it can involve improving business offerings by gaining insight from customers through methods of customer input. “Reducing friction points—learning curves, waiting periods, paperwork, delivery charges, and so on—in the customer experience will encourage them to use and recommend your business more often,” says Bierman.
However it’s done, increasing sales volume allows for better coverage of fixed costs, which can lead to higher profitability. Cutting expenses is often the focus of efforts to boost EBITDA, because those savings may fall straight to the bottom line. “If the business is not continually reviewing and updating its existing and potential vendor lists, it may overspend on supplies or inventory,” McNeilly says.
To cut back on spending and free up more cash, you might want to look into increasing your insurance deductible, and reviewing service plans for basic business services such as telephones, internet, and equipment leasing. Businesses that are willing to negotiate with their service and goods providers may be able to trim some expenses, improving EBITDA.
Sometimes it helps to benchmark the financial performance of the company to that of peers to guide efforts to improve EBITDA to assets. Doing so can help identify areas where a business lags—in net profit margin, for example, or inventory turnover.
In short—improve your EBITDA-assets ratio by:
- Increasing sales volume and revenue through customer suggestions and sales planning
- Cutting supply or inventory expenses through vendor selection and contract negotiations
- Reviewing overhead expenses such as telephone or equipment
- Benchmarking the company to its peers and identifying areas to improve
3. Debt service coverage ratio
The debt service coverage ratio can be found by dividing EBITDA by a firm’s current portion of long-term debt and interest expense. It is an extremely important metric for predicting default. More than half of the banks and asset-based lenders in a Pepperdine survey said this statistic was important or very important in their lending decisions.
How to improve your debt service coverage ratio
In addition to improving the EBITDA-assets ratio, a business can also improve this ratio by focusing on debt and interest expense.
One effective way of tackling the debt/interest side of this ratio is to cut expenses. “Sell things that can boost cash, such as unproductive assets,” advises Bierman. “These are assets that are not contributing sufficiently to the generation of income and cash flow, possibly because they are under-utilized. Use the proceeds to pay off principal on your debt.”
Similarly, small decreases in overhead can typically yield large cash savings over time, and the impact of those savings is compounded when they are used to repay principal, lowering debt payments and also interest expenses.
In short—improve your debt service coverage ratio by:
- Focusing on increasing EBITDA, using any of the recommendations from the previous section
- Considering refinancing to lower interest rates and therefore lowering interest expense
- Using available cash to pay off more principal which will, in turn, make interest payments going forward smaller
- Reducing opportunities for business fraud within the company, which can inflate costs of sales
4. Liabilities-assets ratio
The liabilities-assets ratio shows how much of a company’s assets are financed through debt, as opposed to financed through profits from the business. Higher ratios of liabilities to assets often result in higher interest rates on debt, reflecting the lender’s view that the borrower is more of a risk. Banks and commercial lenders want this ratio to be as low as possible, but generally below 1:1.
As Citibank advises potential customers, lenders seek low ratios because they don’t want a business to be struggling to repay its debt. “The more debt you have, the more of your cash flow you’ve committed to supporting that debt,” notes Collins of Bryant University. Rebel Cole, professor of finance at DePaul University, says creditors understandably place an emphasis on this metric when reviewing a potential borrower. “If they don’t have any debt, they’re not very likely to go into default—it’s virtually impossible.”
How to improve your liabilities-assets ratio
Improving this ratio is all about reducing debt. This means making the highest possible debt payment each month, especially on small-business credit cards. In addition to hurting a business’s liabilities-assets ratio, the high balances that can quickly accumulate on credit cards can cost a business a lot of money in interest charges.
In short—improve your liabilities-assets ratio by:
- Aiming to keep this ratio at or lower than 1:1
- Making the highest possible monthly payment toward credit card debt
- Reducing total debt by paying off more principal
5. Net income-sales ratio
The net income-sales ratio is a fundamental measure of how profitable your business is. It is found by dividing net income by total sales.
How to improve your net income-sales ratio
To improve the income to sales ratio, increasing profitability is key.
There are three possible fixes for low profitability, according to “Financial Intelligence for Entrepreneurs,” by Karen Berman, Joe Knight, and John Case. One option—cutting operating expenses—can be more of a short-term fix. Two of the fixes—increasing profitable sales and lowering production costs—take time to identify and implement.
Lowering production costs often involves finding ways to get raw materials or key services more cheaply or to use less of them. Or it can mean identifying new, more efficient methods of producing a good or providing a service.
To increase profitable sales, according to Berman, Knight, and Case, “You have to find new markets or new prospects, work through the sales cycle, and so on.” Lowering the cost of goods sold typically involves studying the production process, finding inefficiencies, and implementing changes. Converting browsers into buyers by scheduling operational duties (such as receiving) to take place at a time customers aren’t likely to need assistance is one way to optimize sales.
In short—improve your net income-sales ratio by:
- Focusing on reducing overhead expenses (but these may not be sustainable and may be one-time savings)
- Increasing sales volume so that fixed costs are spread further, improving profitability
- Seeking advice from customers as to how the company can optimize their offering for the customer
- Finding a new market, potentially boosting sales
Even if your business isn’t seeking a loan right now, improving these financial statement ratios is essential for improvement.
By monitoring these key financial metrics, small business owners will see increased performance within their company, such as increased revenues and profits, reduced interest payments and overhead expenses, and a greater attention to customer feedback overall.