The Center For Debt Management
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The Credit Process: A Guide
For Small Business Owners

... Continued From Previous Page

Liquidity

How much cash does your business have on hand for immediate use?

Quick Ratio

The quick ratio shows what assets your business can immediately convert to cash, such as the business checking account and money market accounts.

Current Ratio

The current ratio is a broader indication of liquidity because it includes inventory. For purposes of showing your immediate access to cash, many lenders find it less useful than the quick ratio. In general, lenders look for your current assets to exceed your current liabilities.

Leverage

The leverage ratios measure the company's use of borrowed funds in relation to the amount of funds provided by the shareholders or owners. These ratios tell the lender how much money you have borrowed versus what money you and other owners have put into your company. This is important because borrowed money carries interest costs and your business must generate sufficient cash flow to cover the interest and principal amounts due to the lender. Generally speaking, companies with higher debt levels will have higher interest costs to cover each month, so low to moderate leverage is nearly always viewed more favorably by prospective lenders.

Debt Ratio

The most common leverage ratio is called, simply, the debt ratio:

Turnover

The turnover ratios focus on the operating cycle of your business by examining its cash flow. They show the amount of time it takes for cash to move through the accounts receivable, inventory account, and accounts payable in your business.

It is important to know how many days it takes your company to purchase inventory, pay for it, sell it, and collect the cash for the sales. Those sales you make on the customer's promise to pay at a later date (also known as credit sales) may not actually produce cash for 30 to 60 days. You can get squeezed if you don't understand this cycle and find that you have to pay for new supplies before your customers have paid you.

Gaining an understanding of the cash flow of your business is the most important financial planning tool you have. An examination of the turnover ratios can help you to understand the operating cycle in your business.

The three turnover ratios are the collection period ratio, the days to sell inventory ratio, and the days purchases in accounts payable ratio.

Collection Period Ratio

First, the collection period ratio indicates how quickly you collect the cash your customers owe you. The earlier you collect it, the sooner you can put it to work purchasing more inventory or paying for current orders; so the lower the number, the better.

Days to Sell Inventory Ratio

Along the same lines is the second turnover ratio, the days to sell inventory ratio. The days to sell inventory ratio tells how efficient you are at matching your purchases to your sales. Low inventory days indicate that you've accurately forecasted the demand for your product. That way excess inventory isn't accumulating on your shelves and adding to costs.

Days Purchases in Accounts Payable Ratio

The days purchases in accounts payable ratio is the third turnover ratio. This ratio measures how quickly you pay your suppliers for inventory purchased. Generally speaking, it is advantageous for small businesses to pay for products promptly so they can take advantage of price discounts.

Pro Forma Financial Statements and Financial Projections

Pro forma financial statements are the entrepreneur's best guess about what next year will look like for the business. These tools will help you anticipate whether next year's cash flow will be sufficient to cover all your costs, and if not, how much money you will need to borrow.

For a longer horizon, financial projections permit you to make estimates about future sales levels, expansion costs, or general business conditions and see how such conditions would affect your company's financial results in the years to come.

The preparation of pro formas and projections is a complex exercise that requires a sound knowledge of financial accounting. A comprehensive discussion of these tools is beyond the scope of this text. However, with the help of your accountant or the advice of one of the sources listed in the Information Guide, the exercise can provide both you and your potential lenders with valuable insights into your business.

These are pro forma financial statements for F.E.D. Foods Company, which expects its sales to increase by 25 percent for 1994. The pro forma statements show how an expected sales increase will change the company's profit and loss statement and balance sheet forecast for next year.

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