Many businesses find it necessary at some point to borrow funds. Lenders need to assess the credit worthiness of borrowers. Two determinants of credit worthiness are the existence and extent of collateral and the liquidity of the business. The balance sheet can be useful in assessing both factors. Collateral are those assets that are pledged by a lender to secure a loan. Even though assets, particularly fixed assets, are not reported at current fair market values on the balance sheet, the lender can determine the kind of assets the business owns and the extent of debt to other lenders. It is usually not difficult for lenders to reach reasonable estimates of the current liquidating values of most business assets, so their absence on the balance sheet usually is not a major problem.
Liquidity is another useful determinant of credit worthiness. Liquidity refers to the availability of cash to the business. Obviously, lenders are concerned whether borrowers will have sufficient cash to repay loans. Liquidity is mainly a function of profitability. Ordinarily, the more profitable the business, the more cash available. However, liquidity is not simply a function of profitability, and firms of comparable profitability do not necessarily have comparable liquidity.
Other factors affecting liquidity are the rates at which accounts receivable and inventory are converted to cash. A business that collects its accounts receivable in an average of 20 days generally has more cash on hand than a business that requires 45 days. Similarly, a business that turns over its inventory 15 times a year has more cash on hand than a company that turns its inventory only 10 times a year.
Another indication of relative liquidity is the ratio of current assets to current liabilities. All other things being equal, a business that has a higher ratio of current assets to current liabilities is more liquid than a company with a lower ratio. A company’s balance sheet may be used by a creditor to measure its liquidity through the use of ratio analysis.
The two most widely used liquidity ratios are the current ratio and the quick ratio.
Looking back at Joint Ventures’ balance sheet, notice that it had $20,413 of current assets and $9,552 of current liabilities. This yields a current ratio of 2.13:
Because certain current assets, such as inventory and prepaids, are not immediately convertible to cash, the quick ratio is often used as an alternative measure of liquidity.
Quick assets are cash, marketable securities and receivables. Joint Ventures’ quick assets are $19,138, yielding a quick ratio of 2.00:
Generally, creditors want these ratios to at least equal to one. If the ratios fall below one, the firm’s current liabilities exceed its current or quick assets, which is not good if you are a creditor.
Another important set of liquidity ratios for a business with significant credit sales is the accounts receivable turnover and average collection period ratios.
Credit sales are all non-cash sales. Average accounts receivable is the average of the beginning and end of period balances. The higher the turnover, the quicker the collections.
Assuming that all $90,000 of Joint Ventures’ delivery revenue were credit sales, and its average net accounts receivable was $15,000, the accounts receivable turnover would be six:
An even more useful measure of the effectiveness of a firm’s collections is the Average Collection Period:
This is a more useful ratio because it computes the average number of days it takes to collect accounts receivable. If a business extends credit for 30 days, its average collection period should not be much greater than 30.
Since Joint Ventures’ accounts receivable turnover was six, its average collection period would be about 60 days:
This collection period would be considered too long if the firm’s policy is to demand payment in 30 days.
For businesses that sell inventory a very important liquidity measure is inventory turnover.
Average inventory is the average of the beginning and ending inventory. What does inventory turnover measure? It literally measures how quickly inventory sells. The higher the ratio, the more quickly the inventory moves. Quick turnover is desirable because it means that goods are more quickly turned into cash. A quick turnover of inventory may be an indication that a firm is selling the right products. On the other hand, too quick a turnover may mean that a company is pricing its products too low.
Example. Janis had $50,000 of cost of goods sold and an average inventory of $2,500 during the recent year. This means that her inventory turnover was 20 (50,000/2,500). This may seem like a reasonable turnover for her product. But is it? It would help to have information about other firms’ operating in the same industry. For most types of firms such information is available.
Creditors also are interested in a debtor firm’s leverage. Leverage is the to degree which a business finances itself with debt, instead of equity. Increasing reliance on debt increases the rate of return on equity in a profitable business, but also increases the risk of going under, due to too much debt. Here is an example of how leverage works.
Example. Hansel and Gretel Grimm are contemplating opening a guided tour company called Babes in the Woods. They project they will need to raise $10,000 to start operations. They have a choice of borrowing half the needed funds, or using only their own funds. They believe the business will generate about $1,000 a year in net profit. If they do no borrowing, their equity will be $10,000 and the expected return on equity (net income/equity) will be 10% ($1,000/$10,000). On the other hand if they borrow $5,000 and use just $5,000 of their own funds, the expected return will be 20% ($1,000/$5,000).
Although leverage is often regarded favorably by borrowers, lenders view it negatively. A high degree of investment by owners provides a greater incentive for the owners to succeed. If the owners have very little of their own money invested, it is psychologically easier for the owners to walk away from a struggling business. Lenders, thus, want to lend to firms in which the owners have a large investment. A common measure of leverage is the debt to equity ratio.
In a small to medium sized business, it is not uncommon to have ratios between 3 and 4. This means for every dollar the owner contributes, there is between $3 and $4 of debt. Joint Ventures’ total debt was $16,177 and its total equity was $15,484, yielding a debt to equity ratio of a little over 1.