3 ratios to monitor the long-term financial health of your business after COVID-19
Over the last three months, we have heard from many business owners telling us about the disruption in their business operations.
Managing cash has been key source of anxiety. Coupled with the introduction of new safety precautions and the importance of maintaining transparent, open communications with both employees and customers, this has put a lot of pressure on entrepreneurs.
As a result, many companies have turned to their lenders to take out new loans to see them through the crisis.
I want to build on what I previously discussed in other blog posts on cash flow and working capital to focus on the role of different types of financing for businesses as well as the three financial ratios that every entrepreneur should monitor to ensure their long term financial health in the wake of the COVID-19 crisis.
3 types of external financing for businesses
Broadly speaking there are three types of external financing:
- Short-term operating line
- Long-term debt financing
- Long-term equity financing
The operating line is there to help you ride the day-to-day swings in cash. This volatility arises from the timing of customer inflows and expense outflows. Those day-to-day swings are hard to control because it is difficult to predict inflows. Your banker understands this and tolerates these swings provided you are not perpetually overdrawn.
Long-term financing comes in the form of cash infusions from investors (equity financing) or lenders (debt financing) and is considered long term because repayment extends beyond one year.
Long-term financing is typically used to:
- Pursue profitable growth opportunities
- Provide liquidity to support long cash conversion cycles
- Support acquisition of capital assets
As the pandemic shut down or slowed businesses, companies had to draw down their line of credit. To ensure that companies had enough cash to stay in business, various levels of government implemented financial relief measures in the form of long-term debt.
Create budgets to guide you through the recovery
Many of these long-term loans are offered in partnership with private lenders and should be accessed by contacting with your primary financial institution.
When you submit your applications, bankers will ask to see a cash flow plan. Your lender could also ask for a projection for anywhere from six to 12 months.
These projections set out anticipated flows on a month to month basis and inform financing needs. The forecast also helps lenders and investors understand how you anticipate your recovery will occur.
We suggest that you look beyond 12 months and start to create budgets and plans for the term of the COVID-19 relief loan period to guide your recovery.
You will have a clear understanding of your own financial health and debt servicing capacity and begin to establish the needed discipline to stay on track. You will have more peace of mind because you have quantified the uncertainty. And this may increase your chances of getting a loan.
Three leverage ratios to monitor your long-term financial health
One of the best ways to ensure you can repay your loan is to keep a close eye on your leverage ratios.
These ratios provide an indication of the long-term solvency of a company and to what extent you are using long-term debt to support your business.
Three ratios are particularly important when applying for a loan.
1. Debt-to-equity ratio
Bankers watch this indicator closely as a measure of your capacity to repay your debts. Debt capacity shows both a company’s ability to service its current debt payments and its ability to raise cash through new debt, if necessary.
The higher a company’s debt-to-equity ratio, the more it is said to be leveraged. Highly leveraged companies carry more risk of missing debt payments when revenues decline. They are also less able to raise new debt. Generally, the debt-to-equity ratio should not be more than two to one, but that ratio varies according to industry standards.
2. Debt service coverage ratio
The debt service coverage ratio measures a company’s ability to make debt payments on time. It is calculated taking a company’s earnings before interest, taxes, depreciation and amortization (EBITDA) and dividing it by interest and principal payment expenses.
Essentially, the debt service coverage ratio shows how much cash a company generates for every dollar of principal and interest owed. This ratio shouldn’t be below two, meaning that your EBITDA should be able to cover interest and principal payments two times.
3. Debt-to-asset ratio
The debt-to-total-assets ratio shows the percentage of a company’s assets financed by creditors. A high ratio indicates a substantial dependence on debt and could be a sign of financial weakness.
The debt-to-total assets ratio is primarily used to measure a company’s ability to raise cash from new debt. That evaluation is made by comparing the ratio to other companies in the same industry.
The debt-to-total-assets ratio is calculated by dividing a company’s total debt by its total assets. You can also use our online calculator.
Stick to your cash flow and operational plan
Finally, as businesses recuperate from the crisis, I want to stress the importance of sticking to your operational and cash flow plan. Do not get distracted with opportunities that look good on the surface. All opportunities need to be evaluated based on how much profit they add to your business.
Keep a close eye on your cash inflows and outflows and don’t wait until it is too late to ask for financing.
Stay healthy and keep your business in good health!