Use these simple metrics to evaluate your company’s financial health
By Jeffrey Simpson, Managing Director, Angus Finance
Let’s face it, many owners and managers in the fuel distribution industry are great at operations and customer service but turn a blind eye to in-depth evaluation of the financial and banking side of the business.
Whether due to the day-to-day operational demands or a general disdain or lack of understanding of the world of finance, my advice to all those who are “analysis averse” in our industry is the following: Learn just a handful of key, easy-to-calculate financial ratios, and you will gain greater clarity into both the relative strength of your business and the discerning minds of your financing partners and suppliers. When you confront your fears, you will be empowered.
Perhaps this is a bit dramatic, but my point is you should not allow the perceived drudgery of “running the numbers” to keep you from gaining insight into the financial standing of your business. To understand your position, you must first measure it and then compare it to the norms for your industry.
My Favorite Metrics
Over the years, I have seen plenty of articles touting the “most important” financial ratios for owners to track when running a small business. Interestingly, I also noticed they differed from article to article. I won’t profess that certain metrics are the “most important,” as there are a host of operational, profitability, leverage and other key performance indicators that you may find helpful in running your business. However, I’ll share with you my three favorites. They are not the “be-all and end-all,” but they are easy to assemble from your regular financial statements and are reliable indicators of whether or not you may be headed for trouble. And whether your financing partners require you to regularly test them or not, be assured they are watching.
Current Ratio (Current Assets ÷ Current Liabilities)
I’ve listed the most critical one first. Fortunately, it is also the easiest to determine. Current assets include all assets that are expected to turn into cash inside of a year, and for a fuel distribution company these typically include cash, marketable securities, accounts receivable and inventory. Current liabilities typically include accounts payable, budget payments and pre-purchase monies collected from your customers, the current year’s portion of debt payments, and amounts owed on bank lines of credit. Both are commonly identified on balance sheets.
The current ratio is an indicator of your company’s ability to meet its short-term obligations. A high ratio is more favorable to a low one. When this ratio falls below 1.0x, your company is likely entering dangerous territory and its ability to produce the cash necessary to meet short-term obligations to suppliers, vendors, customers and lenders is compromised. A current ratio higher than 1.1x is generally the sign of a healthy company in our industry, however be honest about the variables on your balance sheet that make up this ratio. For example, uncollectable receivables or short-term loans to affiliates should be eliminated from the current asset pool to obtain a true picture of where your company’s liquidity position stands. Weak current ratios can be addressed through various measures by working with your financial advisor, but the first step is to understand your company’s current ratio relative to the above benchmarks.
Cash Flow Leverage Ratio (Total Funded Debt ÷ EBITDA)
Understanding your company’s total debt load in comparison to earnings is another vital metric you should know. A low ratio is more favorable than a high one. In this calculation, total funded debt means the total remaining principal obligations to banks and other loan providers. Due to the seasonal nature of lines of credit to banks, I recommend that you include the average outstanding amount over the course of the year in the total funded debt figure. EBITDA means earnings before interest, taxes, depreciation and amortization for the most recent 12-month period and can quickly be calculated from your profit and loss statement.
In our industry, a cash flow leverage ratio less than 5.0x indicates a company is not carrying too much debt relative to its earnings. Keep in mind that in a challenging year with weak earnings you may experience a very high ratio. As such, examine this ratio over the course of several quarters or multiple years to determine if the trend is problematic. In such a case, action may be required to address the debt load or the profitability targets of the company.
Debt Service Coverage Ratio (Net Operating Income ÷ Annual Principal & Interest)
Many companies have comprehensive banking relationships that require this metric to be tested over 12-month periods. A higher ratio is more favorable than a low one. If a minimum ratio is not met – typically in the range of 1.25x – the company may be in violation of bank requirements. Extended violation of this ratio often leads to strained bank relationships, may result in hefty penalty fees and can imperil your ability to obtain additional financing. Whether your lending partners require you to regularly calculate this ratio or not, it is a meaningful target and therefore good practice to do so on your own to determine if your business is generating ample cash through its regular operations to cover its annual debt obligations, or if you must dip into savings to meet the obligations.
Net operating income is typically listed on your income statement, but it is simply the income remaining after all operating expenses have been paid. Net operating income excludes the impact of extraordinary income or losses. Annual principal and interest may or may not be listed on your company’s financials, but it is easy to obtain from loan payment schedules for a given year.
With a focused effort in as little as 30 minutes, you can obtain a meaningful snapshot of your company’s financial standing and gain insight into how your financing partners view your company. While financial analysis can be very complex, my experience has shown that starting with these three basic, easy-to-calculate ratios is an effective way to gain clarity. Extracting the fundamental strengths and weaknesses of your operation using these ratios leads to sound decisions regarding the establishment of profitability goals, margin setting, expense examination and interaction with financing partners.