Sep 14, 2021What Financial Ratios Do Banks and Investors Care About?
When seeking outside funding, businesses should be aware of the financial ratios investors will examine to determine a company’s financial health. There are many ratios that investors can look at, but this article outlines several of the common financial ratios banks and other investors care about.
Debt-to-Assets and Debt-to-Equity Ratios
The debt-to-assets and debt-to-equity ratios are two popular leverage ratios that indicate a company’s ability to manage their finances long term. Investors want to know if the company they are investing in has the ability to pay them back eventually, and the debt-to-assets and debt-to-equity ratios are a good place to start.
The debt-to-assets ratio is calculated in the following way, where: STD=short term debt and LTD=long term debt:
Total Debt to Total Assets = STD + LTD / Total Assets
If the resulting number is closer to zero, it is a good sign that the company carries less debt compared to its assets.
On the other hand, the debt-to-equity ratio is calculated in the following way:
Debt to Equity= Total Liabilities / Total Shareholders’ Equity
Like the debt-to-assets ratio, the higher debt-to-equity ratio a company has, the higher risk that company is for investors. For example, if a company has $50,000 in loans and $10,000 in equity, their debt-to-assets ratio is 5, meaning for every $1.00 they have in equity, they have $5.00 in debt. Understandably, this would be a concern for investors. A safer and more reliable debt-to-equity ratio will occur when a company’s liabilities are less than their equity.
Working Capital Ratio
The working capital ratio simply calculates the difference between a company’s current assets and its liabilities. It provides a picture of a company’s short-term financial health and helps investors determine whether or not the company has the potential for growth, as well as their ability to pay back liabilities.
To calculate the working capital, a company’s assets (cash, accounts receivable, inventory, etc.) is subtracted by its liabilities (accounts payable, short-term debt payments, taxes, etc.):
Working Capital = Current Assets - Current Liabilities
For example, if a company has $80,000 of assets and $50,000 worth of liabilities, their current working capital would be $30,000. This indicates that the company has a positive working capital they can use to fund their current operations as well as invest in future ventures.
Another ratio investors examine is the quick ratio or acid-test ratio. The quick ratio looks at short-term assets and compares it to short-term liabilities in order to determine if a company can pay its immediate liabilities. While similar to the working capital ratio, the quick ratio does not include assets that are difficult to quickly liquidate, like inventory. The quick ratio is calculated using the following formula:
Quick Ratio = (Cash + Marketable Securities + Accounts Receivable) / Current Liabilities
Most importantly, the numerator in this equation should include all current assets and exclude assets that cannot be easily converted into cash, like inventory. The denominator should include the current liabilities that are due within the year.
Another ratio banks and investors will examine is the loan-to-value ratio. Usually, this ratio is used when a company is seeking a loan for something specific, like a property or large asset, and banks will assess their lending risk before approving a loan. The loan-to-value ratio is calculated as follows:
Loan-to-Value Ratio = Amount of Loan / Value of Asset
With this formula, if a bank approves a loan of $80,000, for a property (or asset) worth $100,000, then the loan-to-value ratio would be 80%. The remaining 20% of the asset would then need to be paid by the business (or borrower). Like the other ratios previously discussed, the higher the Loan-to-Value Ratio, the higher the risk for the investor.
The ratios discussed in this article are only a few of the many ratios that help potential investors analyze the financial health of a company. It is important to note that using one ratio will provide only a portion of the financial picture an investor needs to make a sound investment. Multiple financial ratios should be examined for the most accurate information regarding a company’s financial health.