You can analyze balance sheet numbers through a series of ratio tests to draw conclusions, check your cash status, and track your debt. Because these are the types of tests financial institutions and potential investors use to determine whether or not to loan money to or invest in your company, it’s a good idea to run these tests yourself before seeking loans or investors.
Testing your cash
When you approach a bank or other financial institution for a loan, you can expect the lender to use one of two ratios to test your cash flow: the current ratio and the acid test ratio (also known as the quick ratio).
This ratio compares your current assets to your current liabilities. It provides a quick glimpse of your company’s ability to pay its bills.
The formula for calculating the current ratio is:
Current assets ÷ Current liabilities = Current ratio
The following is an example of a current ratio calculation:
$5,200 ÷ $2,200 = 2.36 (current ratio)
Lenders usually look for current ratios of 1.2 to 2, so any financial institution would consider a current ratio of 2.36 a good sign. A current ratio under 1 is considered a danger sign because it indicates the company doesn’t have enough cash to pay its current bills.
A current ratio over 2.0 may indicate that your company isn’t investing its assets well and may be able to make better use of its current assets. For example, if your company is holding a lot of cash, you may want to invest that money in some long-term assets, such as additional equipment, that you need to help grow the business.
Acid test (quick) ratio
The acid test ratio only uses the financial figures in your company’s Cash account, Accounts Receivable, and Marketable Securities. Although it’s similar to the current ratio in that it examines current assets and liabilities, the acid test ratio is a stricter test of a company’s ability to pay bills.
The assets part of this calculation doesn’t take inventory into account because it can’t always be converted to cash as quickly as other current assets and because, in a slow market, selling your inventory may take a while.
Many lenders prefer the acid test ratio when determining whether or not to give you a loan because of its strictness.
Calculating the acid test ratio is a two-step process:
Determine your quick assets.
Cash + Accounts Receivable + Marketable Securities = Quick assets
Calculate your quick ratio.
Quick assets ÷ Current liabilities = Quick ratio
The following is an example of an acid test ratio calculation:
$2,000 + $1,000 + $1,000 = $4,000 (quick assets)
$4,000 ÷ $2,200 = 1.8 (acid test ratio)
Lenders consider a company with an acid test ratio around 1 to be in good condition. An acid test ratio less than 1 indicates that the company may have to sell some of its marketable securities or take on additional debt until it’s able to sell more of its inventory.
Assessing your debt
Before you even consider whether or not to take on additional debt, you should always check out your debt condition. One common ratio that you can use to assess your company’s debt position is the debt to equity ratio. This ratio compares what your business owes to what your business owns.
Calculating your debt to equity ratio is a two-step process:
Calculate your total debt.
Current liabilities + Long-term liabilities = Total debt
Calculate your debt to equity ratio.
Total debt ÷ Equity = Debt to equity ratio
The following is an example of a debt to equity ratio calculation:
$2,200 + $29,150 = $31,350 (total debt)
$31,350 ÷ $9,500 = 3.3 (debt to equity ratio)
Lenders like to see a debt to equity ratio close to 1 because it indicates that the amount of debt is equal to the amount of equity. With a debt to equity ratio of 3.3, most banks probably would not loan the company in this example any more money until either its debt levels were lowered or the owners put more money into the company.