Capital and Financial Ratios
Raising Capital and Financial Ratios
Growing a company requires capital – whether it’s from a bank loan, equity infusion, or reinvesting of profits from internal operations. Without new capital, most businesses find it difficult to develop new products or services, hire additional employees or invest in new equipment. Only a few lucky businesses can suitably finance growth through internal operations. When opportunity for growth knocks, many business owners must decide whether to borrow money or sell partial ownership in the company to raise the necessary funds. Each method has its advantages and disadvantages and before seeking new capital, it is important to understand how investors and lenders look at your company through its financial ratios.
Debt vs. Equity Financing
Raising funds via a loan can be expensive. However, for a business owner that is not inclined to change the ownership structure of the company, this is an easy way to augment the natural growth of the company. Lenders are primarily interested in earning fees and interest and receiving the balance of the loan back according to some set of agreed to terms. As long as these conditions are met by the borrowing company, lenders have little reason to exert control over the operations of the business.
Another option for generating growth capital is through equity financing. In this case the owner sells shares or an interest in the company to investors. These could be individual “angel” investors that typically invest in small companies and take on a mentoring role. Or, these investors could be investment organizations such as private equity firms or venture capital funds. When selling a partial interest in the company, the owner is giving up a portion of future profits and may be required to give up some control over their operation.
Key Financial Ratios
When evaluating a business for a loan or investment, lenders and investors look at several financial ratios to help them make a risk assessment. It’s important to understand what these ratios tell a prospective decision maker.
Used by Lenders…
The quick ratio represents cash plus accounts receivable, divided by current liabilities. It shows whether short-term assets are capable of covering short-term debts should funds have to be repaid in a crunch. The higher this “liquidity ratio,” the more likely a lender will approve the loan request.
The times-interest-earned ratio expresses earnings before interest and tax expenses, divided by interest owed on borrowed funds. It tells a lender how much of a company’s cash flow is available to cover interest payments. The higher this “coverage ratio,” the more credit worthy a company is considered.
The debt-to-equity ratio compares total liabilities to shareholder equity. The resulting number measures a company’s leverage – the degree to which assets are financed through debt or earnings and stock sales. The lower the ratio, the more moderate a company’s debt load and thus the more likely a lender will look upon providing additional debt financing.
Used by investors…
The return-on-equity (ROE) ratio represents after-tax net income, divided by average net worth. This indicates the percentage shareholders are earning on their investment. The higher the ROE, the better the shareholder return and the more attractive a business will look to investors.
The return-on-assets (ROA) ratio compares earnings to total assets. This broader measure of profitability is of interest to investors and lenders alike. The higher the ratio, the more profitable is the business.
Test Your Company
Whichever route to raising capital an owner decides to follow – debt or equity financing – they should be prepared for intense scrutiny of their financial statements. Understanding the key financial ratios and improving their appearance may mean the difference between obtaining the needed capital for growth and not. Business owners are served well by reviewing the key ratios of their company and comparing these to their industry’s norms. If you find some ratios fall outside industry standards, meet with your accountant, business advisors, and management team to take the necessary steps to improv
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Brad Elliott is Principal/Broker at VR Business Brokers in Ewing, NJ. Brad himself has owned, operated, and sold a multitude of small to mid-sized businesses over the last 15 years. Brad received his MBA from MIT’s Sloan School of Management and comes from a family of entrepreneurs.
