Accounting 101: Calculating Financial Ratios
By Linda Plater | September 30, 2001
Last month we looked at the value of understanding ratios when you go to the bank for a loan. Without going into too much detail here, here's a look at some of the most common ratios used by financial folks when they look at your books. If you want to get financed, it's important to understand the importance of these ratios and what they tell the banker about your business.
Ratios: click on a link to jump directly to the explanation of that ratio
The Debt to Equity Ratio
When you apply for a loan or line of credit, this will be one of the first ratios that your banker will look at. In essence, it tells the bank how much money you have invested into your business, for every dollar of debt that lenders have put in.
To calculate your debt to equity ratio, you divide your total liabilities by the owner's equity:
Owner's equity
Debt to equity ratio example: Company ABC, which has been in operation for five years, currently has total liabilities of $125,000 and their owners' equity is $75,000.
|
$125,000 $75,000 |
=1.67 |
Ideally, the banks want to see a ratio of 2:1, which equates to a 2.0 or less. As your ratios edge above this level the loan becomes a riskier proposition for the bank, and there is a good chance that your credit application will be declined.
Use our ratio calculator to calculate your debt to equity ratio.
Current Ratio
The current ratio tells a lender about the liquidity of your assets, and as a result it says a lot about your ability to pay your short term debts. To calculate your current ratio, your current assets are divided by your current liabilities:
Current liabilities
Current ratio example: Company ABC has current assets of $75,000 and current liabilities of $60,000, so their current ratio is:
|
$75,000 $60,000 |
=1.25 |
Use our ratio calculator to calculate your current ratio.
Debt Service or Coverage Ratio
The coverage ratio is an indicator of your company's ability to pay its overall debts. This ratio is calculated by dividing your net operating income by your total debt service:
Total Debt Service
Coverage ratio example: Company ABC has a net operating income of $185,000 and a total debt service of $100,000:
|
$185,000 $100,000 |
=1.85 |
Ideally, you want your coverage ratio to be over 1.0, as this indicates that your operating income is sufficient to cover your total debt service.
The Times Interest Earned (TIE) Ratio
Like the debt service ratio, TIE may be used by bankers to assess your ability to pay your liabilities. The TIE ratio determines how many times during the year your business has earned the annual interest costs associated with servicing its debt.
To calculate your TIE, you must divide your profit before interest and income taxes by the total interest charges:
Total Interest Charges
TIE ratio example: Company ABC's profit before interest and taxes is $22, 000 and its total interest charges are $10,000:
|
$22,000 $10,000 |
=2.2 |
Your banker will be looking for your TIE ratio to be 2.0 or greater, showing that your business is earning the interest charges two or more times each year.
Use our ratio calculator to calculate your TIE ratio.
The Quick Ratio
Also known as the Acid Test or Cash Ratio, bankers use this ratio to determine how quickly you would be able to pay off your current liabilities if you needed to convert your "quick" assets into cash. This ratio differs from the Current Ratio in that it excludes inventory. The logic behind this is that while inventory may have been paid for and has value, it may not necessarily be converted into cash quickly.
Calculation method #1:
Current liabilities
Calculation method #2:
Since the purpose of this ratio is to exclude inventory, it can also be calculated by adding Cash and Convertibles and other Current Assets (that exclude inventory and prepaid items), and dividing that by the Current liabilities:
Current liabilities
Quick ratio example, using method 1: Company ABC's total current assets are $75,000, and its current liabilities are $60,000. It's current inventory is valued at $8,500, which gives it a quick ratio of:
|
($75,000 - $8,500) $60,000 |
=1.11 |
If the numbers used to calculate these ratios make your head spin, be sure to read Accounting 101, where we will explain balance sheet basics and other accounting fundamentals in simple terms!
