I was recently meeting with a client with whom I have done business with for several years. I always love our interactions because I know we will cover the business-of-the-day, but not before we talk about what is going on in our personal lives. Our interaction is never forced, and it has become clear over our numerous engagements that we truly enjoy each other's company. As a result, the trust we have built has allowed us to become more efficient in the business we conduct. We are able to have very efficient and effective meetings because we have come to know that we both have the other's best interests in mind.
Sales organizations always try to reinforce the power of rapport building, but very few are actually successful. I think this is why you often see many sales reps turning over so quickly, they fail to take enough time to truly develop meaningful relationships, and therefore, are unsuccessful. The individuals representing these organizations fail to connect with the customer on a truly personal level. They fail to successfully understand that trust is the building block of any successful business relationship. It isn't enough to know the names of their children, remember birthdays, and how many siblings they have, but rather, the successful building of trust is built on a culmination of past experiences.
Think of someone who you truly respect and trust. What experiences have you had with that individual that forged those relationships? Were you teammates, business partners, is it your spouse or family member? Now think about the defining experiences that helped to either strengthen or weaken those bonds. Conversely, think about someone who you don't quite trust or respect. Here too, past experiences can play a part, but also, lack of experience also plays a strong role. Most often, past experiences that have tarnished trust and respect are hard to rebuild, but when mended successfully, can actually lead to even stronger bonds in the future. Lack of meaningful past experiences creates a sense of indifference, and in the business world, indifference is just as toxic as poor past experiences.
If sales professionals are to be successful in building long-term relationships with their clients, they must therefore focus on creating experiences that focus on building trust and respect. If professionals can think of every interaction in these terms it will automatically lead to building better relationships. Take this in contrast with someone who is simply out to remember names and dates so as to appear as though they are close with their customers. Anybody who is proficient at using their Outlook calendar can accomplish this task, but it takes someone who truly cares about their customers to have something on their calendar that actually means something to their customer. An invitation to a daughter's wedding, or a son's graduation. These are the types of events that expose a person's vulnerability, which is a crucial aspect of building any relationship.
In summary, successful business interactions begin with the process of developing trust and respect. From the cold-call to closing, business professionals need to be cognizant of their actions and how it is either leading towards, or away from, trusting relationships. By consciously keeping this in mind, sales representatives, and business professionals alike, should experience stronger results and deeper customer relationships.
Friday, October 28, 2011
Tuesday, February 15, 2011
Banks Are Ready To Lend But Is Your Business Ready to Borrow
The end of 2007 marked a historic period in our nation's history. For most, the next few years would become the worst financial disaster any of us had ever witnessed.
For Wall Street, the period between 2008 and 2009 would forever change the financial landscape. Pillars of strength such as Lehman Brothers and Bear Stearns seemed to fail overnight. Like a house of cards the corporate world seemed to be falling all around us as one firm after another either failed or was left kneeling at the feet of congress asking for mercy, or better yet, a bailout.
Perhaps most impactful was what was happening on Main Street. Due to many of the mistakes made on Wall Street many Main Street businesses would now suffer as their local banking institutions panicked and ceased to extend credit. Further exacerbating the issue was the fact that many small community banks relied on larger regional or national banks for liquidity as their correspondent bank. Nervous from their own internal issues, many of these banks cut off liquidity to the smaller banks to let them fend for themselves.
Today, the dust has settled, TARP money has been all but repaid, GM has risen from the ashes, and the economy continues to slowly recover. With that being said, most commercial banks are starting to open up the coffers once again. What does this imply for the small and medium sized business owner? Do they need to simply show up to the door with hands open? It is important for the business owner to realize that while banks are seeking to increase their lending activity over the foreseeable future, they are undoubtedly going to be more conservative and cautious given recent experiences. Businesses need to be prepared to secure the capital their business needs, and they need to be aware of what will be required of them that may not have been historically. All business owners can benefit from taking 5 simple steps before approaching any bank with a lending request.
1) Be Profitable or Have a Really Good Story:
It is important for many banks to work with companies who have a strong earnings history. Does your business demonstrate a net profit? If so, how many years has it been profitable? If you haven't demonstrated at least 3 years of consecutive net profit, you may want to consider formulating your story as to why, and back that up with forward-looking projections demonstrating a return to profitability in the near future. Net losses over the past couple years is not necessarily the kiss of death, but without a plan for the future or an explanation for the past, many lender's will find it hard to get comfortable with lending money at any dollar amount. Most commercial banks are cash-flow lenders and don't care so much as to how much collateral you have. Some do, and those would be asset based lenders, but conventionally speaking, just like cash is king, to the commercial banker cash-flow is king.
It is important to note, however, that positive net income does not always translate into sufficient cash flow to service new or proposed debt. An easy formula that most banks use to calculate cash flow to service debt is EBITDA (Earnings before Interest Taxes Depreciation and Amortization) divided by principal payments plus interest expense. Stated in mathematical terms:
Net Income (Net Loss)
+ Interest Expense
+ Amortization Expense
+ Tax Expense/Provision for Income Tax (C-Corp)
+ Depreciation Expense
=EBITDA divided by Annual Principal Payments plus Interest Expense
Most commercial banks will look for this ratio to equal 1.00 or greater, but be ready to expect a requirement of more like 1.25 versus 1.00, which gives banks additional comfort by adding in a small cushion.
2) Don't Ignore the Balance Sheet:
Most businesses simply focus on the income statement when asking their banker for a loan. Don't ignore the importance of a strong balance sheet. It is important that the balance sheet represent ample liquidity and reasonable financial leverage. In a previous blog I wrote about the importance of financial ratio analysis for the small business owner and covered some common ratios used in financial analysis. The most common ratios banks will look at is the current ratio (current assets divided by current liabilities) and the debt/equity ratio (total liabilities divided by total equity). Generally, banks want the current ratio to be at least or greater than 1.00 and the debt to equity ratio to be less than 4.00 or 5.00 at the most. If your business has negative retained earnings, as many do after the past couple of years, you may want to focus on whether assets on the balance sheet have more value than what is actually being reflected. Many assets that have been on the balance sheet for a number of years are probably full depreciated and may understate the market value of the company's equity account. In this case, it may be beneficial to determine the market value through an outside appraisal. Some banks may require an appraisal as a condition of loan closing, so when working with your bank make sure they are comfortable with you ordering it on your own so you aren't required to pay for more than one.
3) Is Your Personal Financial House In Order:
While much of the focus in commercial lending is concentrated on whether the business can support the loan request, there is a considerable amount of focus placed on the owners of the business. If you haven't checked your personal credit report in some time, make sure you know your score and be able to explain any derogatory items. Most commercial banks will find it hard to consider a loan for a business owner who does not have a strong personal credit score, generally 620 or above, and in recent years this score has been as high as 670.
Additionally, make sure you have at least 2-3 years of personal federal income tax returns available as well as a current personal financial statement (listing of personal assets and liabilities). Most banks will require you to use their form, but it is always a good exercise to figure out net worth on an annual basis on your own prior to approaching a lending institution. Generally speaking, an individual's net worth should increase at a rate greater than the rate of inflation, but of course, extenuating circumstances such as purchasing a home or some other life event may cause large fluctuations (positive or negative) in one's individual net worth. There is no magic number with regards to net worth, but getting back to negative retained earnings mentioned in the section above, adding your personal net worth and the company net worth together should result in a global debt/equity ratio that is less than the 4.00 or 5.00 mentioned above.
4) Be Organized:
Nothing can turn a lender off more than having to sift through piles of financial reports that are unorganized, incomplete, or just plain messy. Lenders are busy and generally have multiple transactions to manage at one time. Being organized and presenting your information in a clear and concise manner can save a substantial amount of time and effort on both sides of the table. As a general rule, a business should be able to present the following information in any loan plackage:
5) Be Educated on Your Options:
Before meeting with your lender, make it a point to talk with your CPA or do research on the internet about some non-conventional lending programs. The US Government has now more than ever put programs in place to help spur small business growth. Organizations such as the USDA and the Small Business Administration (SBA) have partnered with banks to offer enhancements to conventional credit structures to make it easier for business owners to obtain necessary capital. The SBA, for example, partners with lending institutions to offer the SBA Express, 7(a), and 504 loan programs. While each of the programs have differing characteristics, generally speaking, they all help to mitigate some weaknesses in credit structure such as a lack of start-up capital, higher financial leverage, or marginal cash-flow coverage.
There are a variety of websites available that speak to the programs mentioned above:
SBA: http://www.sba.gov/
SCORE: http://www.score.org/ (small business mentoring and training)
USDA: http://www.usda.gov/ (USDA lending programs)
Partnering with a knowledgeable and respected lender can be extremely beneficial in helping business owners navigate through the complex world of government lending programs. Furthermore, when interviewing banks, ask if the bank is a "preferred SBA lender." This status means that the bank is allowed to approve SBA requests on behalf of the SBA, or more simply, has the resources and expertise necessary to make decisions without having to go directly to the SBA. The advantage in working with a preferred SBA lender is the process moves much more quickly since it doesn't have to be packaged and sent directly to the SBA offices for decision.
By following the 5 steps outlined in this article, business owners can ensure they give themselves the best possible chance of securing a commercial loan. While not all loan transactions or banks are the same, the 5 steps outlined in this article attempt to address the commonalities that all lenders are seeking when considering any loan transaction.
For Wall Street, the period between 2008 and 2009 would forever change the financial landscape. Pillars of strength such as Lehman Brothers and Bear Stearns seemed to fail overnight. Like a house of cards the corporate world seemed to be falling all around us as one firm after another either failed or was left kneeling at the feet of congress asking for mercy, or better yet, a bailout.
Perhaps most impactful was what was happening on Main Street. Due to many of the mistakes made on Wall Street many Main Street businesses would now suffer as their local banking institutions panicked and ceased to extend credit. Further exacerbating the issue was the fact that many small community banks relied on larger regional or national banks for liquidity as their correspondent bank. Nervous from their own internal issues, many of these banks cut off liquidity to the smaller banks to let them fend for themselves.
Today, the dust has settled, TARP money has been all but repaid, GM has risen from the ashes, and the economy continues to slowly recover. With that being said, most commercial banks are starting to open up the coffers once again. What does this imply for the small and medium sized business owner? Do they need to simply show up to the door with hands open? It is important for the business owner to realize that while banks are seeking to increase their lending activity over the foreseeable future, they are undoubtedly going to be more conservative and cautious given recent experiences. Businesses need to be prepared to secure the capital their business needs, and they need to be aware of what will be required of them that may not have been historically. All business owners can benefit from taking 5 simple steps before approaching any bank with a lending request.
1) Be Profitable or Have a Really Good Story:
It is important for many banks to work with companies who have a strong earnings history. Does your business demonstrate a net profit? If so, how many years has it been profitable? If you haven't demonstrated at least 3 years of consecutive net profit, you may want to consider formulating your story as to why, and back that up with forward-looking projections demonstrating a return to profitability in the near future. Net losses over the past couple years is not necessarily the kiss of death, but without a plan for the future or an explanation for the past, many lender's will find it hard to get comfortable with lending money at any dollar amount. Most commercial banks are cash-flow lenders and don't care so much as to how much collateral you have. Some do, and those would be asset based lenders, but conventionally speaking, just like cash is king, to the commercial banker cash-flow is king.
It is important to note, however, that positive net income does not always translate into sufficient cash flow to service new or proposed debt. An easy formula that most banks use to calculate cash flow to service debt is EBITDA (Earnings before Interest Taxes Depreciation and Amortization) divided by principal payments plus interest expense. Stated in mathematical terms:
Net Income (Net Loss)
+ Interest Expense
+ Amortization Expense
+ Tax Expense/Provision for Income Tax (C-Corp)
+ Depreciation Expense
=EBITDA divided by Annual Principal Payments plus Interest Expense
Most commercial banks will look for this ratio to equal 1.00 or greater, but be ready to expect a requirement of more like 1.25 versus 1.00, which gives banks additional comfort by adding in a small cushion.
2) Don't Ignore the Balance Sheet:
Most businesses simply focus on the income statement when asking their banker for a loan. Don't ignore the importance of a strong balance sheet. It is important that the balance sheet represent ample liquidity and reasonable financial leverage. In a previous blog I wrote about the importance of financial ratio analysis for the small business owner and covered some common ratios used in financial analysis. The most common ratios banks will look at is the current ratio (current assets divided by current liabilities) and the debt/equity ratio (total liabilities divided by total equity). Generally, banks want the current ratio to be at least or greater than 1.00 and the debt to equity ratio to be less than 4.00 or 5.00 at the most. If your business has negative retained earnings, as many do after the past couple of years, you may want to focus on whether assets on the balance sheet have more value than what is actually being reflected. Many assets that have been on the balance sheet for a number of years are probably full depreciated and may understate the market value of the company's equity account. In this case, it may be beneficial to determine the market value through an outside appraisal. Some banks may require an appraisal as a condition of loan closing, so when working with your bank make sure they are comfortable with you ordering it on your own so you aren't required to pay for more than one.
3) Is Your Personal Financial House In Order:
While much of the focus in commercial lending is concentrated on whether the business can support the loan request, there is a considerable amount of focus placed on the owners of the business. If you haven't checked your personal credit report in some time, make sure you know your score and be able to explain any derogatory items. Most commercial banks will find it hard to consider a loan for a business owner who does not have a strong personal credit score, generally 620 or above, and in recent years this score has been as high as 670.
Additionally, make sure you have at least 2-3 years of personal federal income tax returns available as well as a current personal financial statement (listing of personal assets and liabilities). Most banks will require you to use their form, but it is always a good exercise to figure out net worth on an annual basis on your own prior to approaching a lending institution. Generally speaking, an individual's net worth should increase at a rate greater than the rate of inflation, but of course, extenuating circumstances such as purchasing a home or some other life event may cause large fluctuations (positive or negative) in one's individual net worth. There is no magic number with regards to net worth, but getting back to negative retained earnings mentioned in the section above, adding your personal net worth and the company net worth together should result in a global debt/equity ratio that is less than the 4.00 or 5.00 mentioned above.
4) Be Organized:
Nothing can turn a lender off more than having to sift through piles of financial reports that are unorganized, incomplete, or just plain messy. Lenders are busy and generally have multiple transactions to manage at one time. Being organized and presenting your information in a clear and concise manner can save a substantial amount of time and effort on both sides of the table. As a general rule, a business should be able to present the following information in any loan plackage:
- Brief overview of the business
- Brief bio of the key executive officers
- Brief explanation of what the credit will be used for and how it will be repaid
- 3 Years most recent company financial statements (i.e tax returns, compiled, reviewed, audited stmts)
- 2-3 Years most recent owner federal income tax returns
- Recent personal financial statement for the owner(s)
- Most recent interim balance sheet and income statement with comparable prior year period
- Current A/R and A/P agings
5) Be Educated on Your Options:
Before meeting with your lender, make it a point to talk with your CPA or do research on the internet about some non-conventional lending programs. The US Government has now more than ever put programs in place to help spur small business growth. Organizations such as the USDA and the Small Business Administration (SBA) have partnered with banks to offer enhancements to conventional credit structures to make it easier for business owners to obtain necessary capital. The SBA, for example, partners with lending institutions to offer the SBA Express, 7(a), and 504 loan programs. While each of the programs have differing characteristics, generally speaking, they all help to mitigate some weaknesses in credit structure such as a lack of start-up capital, higher financial leverage, or marginal cash-flow coverage.
There are a variety of websites available that speak to the programs mentioned above:
SBA: http://www.sba.gov/
SCORE: http://www.score.org/ (small business mentoring and training)
USDA: http://www.usda.gov/ (USDA lending programs)
Partnering with a knowledgeable and respected lender can be extremely beneficial in helping business owners navigate through the complex world of government lending programs. Furthermore, when interviewing banks, ask if the bank is a "preferred SBA lender." This status means that the bank is allowed to approve SBA requests on behalf of the SBA, or more simply, has the resources and expertise necessary to make decisions without having to go directly to the SBA. The advantage in working with a preferred SBA lender is the process moves much more quickly since it doesn't have to be packaged and sent directly to the SBA offices for decision.
By following the 5 steps outlined in this article, business owners can ensure they give themselves the best possible chance of securing a commercial loan. While not all loan transactions or banks are the same, the 5 steps outlined in this article attempt to address the commonalities that all lenders are seeking when considering any loan transaction.
Friday, January 21, 2011
The Importance of Financial Ratio Analysis for the Small Business Owner
In my day-to-day job, I tend to come across a wide variety of business owners, which is one of the things I love about what I do. For the larger businesses, it is not uncommon to have segregated departments of accounting and finance, each led by seasoned industry professionals. Many smaller closely held businesses, however, do not have the resources to hire professionals to fill these roles. Rather, many small business owners tend to take on multiple roles, or assign multiple roles to employees in various functional areas of the organization where they may or may not have expertise.
One functional area that I often see get overlooked by many small business owners is the functional discipline of finance. I want to clarify that finance should not be confused with accounting. Many times, business owners will have an individual within the office reconcile the bank statements, post transactions to the general ledger, and serve in the A/R and A/P function, but this is a bookkeeping function not a finance function. I certainly don't intend to downplay the importance of bookkeeping, but many bookkeepers will prepare internal financial statements to give to their CPA and file it away when the task is complete. The area of finance looks forward. It serves to take the accounting information and analyze the historical data to determine the overall health of the organization, and what steps need to be taken in the future to increase overall value to the shareholders.
Business owners and the employees who support the financial aspects of the business should take note to actively engage in trend and ratio analysis. A very clear picture can be painted when financial information is tracked and compared over time (time-series analysis), and against industry "norms" (peer analysis). Financial ratio analysis is not difficult, and there are several key ratios that can tell a lot about a company's financial health.
Liquidity Ratios:
Liquidity ratios are intended to provide information about a firm's ability to pay its bills over the short run without undue stress. These ratios tend to focus on the relationship between current assets and current liabilities. The most widely used of these ratios is the current ratio. Defined as Current Assets divided by Current Liabilities, it measures short-term liquidity. While different industries demonstrate different current ratio norms, generally speaking, the higher the better. A current ratio less than 1 is generally a sign of poor liquidity and means that current assets are less than current liabilities, or more generally, the firm does not have the ability to generate short-term cash to meet its short-term obligations.
Another ratio commonly used, especially by companies who have a substantial amount of inventory, (such as a distributor) may want to look at the Quick Ratio. The Quick Ratio is essentially the current ratio, but deducts inventory from current assets. The ratio is calculated as current assets minus inventory divided by current liabilities. Inventory is generally perceived to be the least liquid (ease of converting an asset to cash) of the current assets and is designed to give a firm an indication of how heavily invested they may be in inventory. A very low quick ratio may signal short-term trouble in that the firm may have overbought, overproduced, or is not turning (selling) inventory quick enough to cover short-term obligations. Again, a ratio below 1 may not necessarily be a warning sign. Owners should take note to compare this ratio to the ratio of businesses of a similar size in the same industry.
Leverage Ratios:
Leverage Ratios are intended to address the firm's long-run ability to meet its obligations, or in other words, its financial leverage. The most common leverage ratio is the debt-to-equity ratio and it is calculated simply as Total Liabilities divided by Total Equity. A debt-to-equity ratio of 1.00 would suggest that the firm has financed operations with as much debt as equity. For example, a firm has $1000 of debt and $1000 of equity ($1000/$1000=1.00). Let's say debt increases to $2,000 due to taking out a loan and equity remains the same. In this case, the debt-to-equity ratio would increase to 2.00, which would suggest that for every dollar of equity, the firm uses twice as much debt to finance operations. As with many ratios, the normal range varies depending on the industry. Capital Intensive industries such as steel foundries and airlines often have high debt to equity ratios because they are generally entering into long-term financing arrangements to acquire revenue producing assets. A word of caution, however, debt-to-equity ratios above 4 to 5 may start to signal high financial leverage, which for many, translates into increased risk in the eyes of creditors and lenders. High financial leverage often carries fixed costs that may be difficult to meet if revenues, margins, and/or expenses move in a negative direction.
Efficiency Ratios:
These ratios are intended to describe how efficiently, or intensively, a firm uses assets to generate sales. One of the most common is the inventory turnover ratio. The inventory turnover ratio is commonly defined as Cost of Goods Sold divided by Inventory (or average inventory). A ratio of 4, for example, tells us that the firm turned over its entire inventory 4 times during the fiscal period being measured. Why is this important? Theoretically, the more a firm turns over its inventory the more cash is being generated. It is also important, especially when compared over multiple periods, in telling the firm whether there may be an inventory management problem such as slow moving SKUs or issues in the purchasing department.
Coupled with the Inventory Turnover Ratio is the Days Sales in Inventory, which is defined as 365 days divided by the Inventory Turnover Ratio. Using our example above of 4, the Days Sales in Inventory Ratio would be 91.25 days (365/4=91.25). This result indicates that on average, the company took 91.25 days to fully turn over its inventory, or conversely, inventory sits for 91.25 before being sold. Generally, the lower the number of days the better as this would indicate the company is converting inventory to cash more frequently thereby generating cash more frequently. Again, comparison with industry norms is the best way to determine whether this area of the business is operating as efficiently as it should be.
Another common efficiency ratio is the Accounts Receivable Turnover Ratio, which is defined as Sales/Accounts Receivable (or average A/R). This ratio tells the company how fast they collect on sales made on credit. If a company demonstrates a ratio of 10, the ratio would indicate that the company collected on outstanding credit and lent the money again 10 times during the year. The meaning of the ratio is more easily understood if put in terms of Days sales in A/R, which is defined as 365/Receivables Turnover Ratio. In our example, the company demonstrates 36.5 A/R days (365/10), which implies the company takes, on average, 36.5 days to collect on its receivables. Like the Days sales in inventory, a lower number is better as it indicates the company is very good at collecting on money that is owed, which thereby increases the amount and frequency in which cash is collected.
Profitability Ratios
Profitability ratios measure how efficiently the company uses its assets and how efficiently the firm manages operations. There are three common ratios; profit margin, return on assets and return on equity. Gross Profit margin is simply calculated as gross profit divided by net income. This ratio can also be calculated as net profit margin (net income/sales) or operating margin (operating profit divided by sales). These ratios tell us how much profit the firm is producing per dollar of sales. For example, if a company generates $1,000,000 in sales and $20,000 the net margin would be 2%, or more generally, generates $.02 of profit for every dollar of sales.
Return on assets (ROA) measures the amount of profit per dollar of assets, and can be defined as net income/total assets (or avg total assets). Using the numbers above, if the company generated net income of $20,000 on assets of $500,000, return on assets would be .04 (or 4%). In this case, the company generates $.04 of profit for every $1 of assets. Consequently, the return on equity (ROE) measure is the same calculation only it places profit in terms of total equity (net income divided by total equity) and measures how the stockholders fared during the year.
It is important to note that I have only outlined some of the more common ratios used by financial managers to measure firm performance. There are many ratios that a company can use, and there are many different variations depending on the source. After working with some of the simpler ratios, like the ones above, a company should work with other ratios to determine which ones are most applicable for their particular business.
A financial manager need not memorize these ratios, but rather, enter them into an excel spreadsheet and calculate them periodically as necessary. Once several periods of data are established trends or "red flags" will start to emerge, which will help pinpoint the areas of the organization that may need attention.
One functional area that I often see get overlooked by many small business owners is the functional discipline of finance. I want to clarify that finance should not be confused with accounting. Many times, business owners will have an individual within the office reconcile the bank statements, post transactions to the general ledger, and serve in the A/R and A/P function, but this is a bookkeeping function not a finance function. I certainly don't intend to downplay the importance of bookkeeping, but many bookkeepers will prepare internal financial statements to give to their CPA and file it away when the task is complete. The area of finance looks forward. It serves to take the accounting information and analyze the historical data to determine the overall health of the organization, and what steps need to be taken in the future to increase overall value to the shareholders.
Business owners and the employees who support the financial aspects of the business should take note to actively engage in trend and ratio analysis. A very clear picture can be painted when financial information is tracked and compared over time (time-series analysis), and against industry "norms" (peer analysis). Financial ratio analysis is not difficult, and there are several key ratios that can tell a lot about a company's financial health.
Liquidity Ratios:
Liquidity ratios are intended to provide information about a firm's ability to pay its bills over the short run without undue stress. These ratios tend to focus on the relationship between current assets and current liabilities. The most widely used of these ratios is the current ratio. Defined as Current Assets divided by Current Liabilities, it measures short-term liquidity. While different industries demonstrate different current ratio norms, generally speaking, the higher the better. A current ratio less than 1 is generally a sign of poor liquidity and means that current assets are less than current liabilities, or more generally, the firm does not have the ability to generate short-term cash to meet its short-term obligations.
Another ratio commonly used, especially by companies who have a substantial amount of inventory, (such as a distributor) may want to look at the Quick Ratio. The Quick Ratio is essentially the current ratio, but deducts inventory from current assets. The ratio is calculated as current assets minus inventory divided by current liabilities. Inventory is generally perceived to be the least liquid (ease of converting an asset to cash) of the current assets and is designed to give a firm an indication of how heavily invested they may be in inventory. A very low quick ratio may signal short-term trouble in that the firm may have overbought, overproduced, or is not turning (selling) inventory quick enough to cover short-term obligations. Again, a ratio below 1 may not necessarily be a warning sign. Owners should take note to compare this ratio to the ratio of businesses of a similar size in the same industry.
Leverage Ratios:
Leverage Ratios are intended to address the firm's long-run ability to meet its obligations, or in other words, its financial leverage. The most common leverage ratio is the debt-to-equity ratio and it is calculated simply as Total Liabilities divided by Total Equity. A debt-to-equity ratio of 1.00 would suggest that the firm has financed operations with as much debt as equity. For example, a firm has $1000 of debt and $1000 of equity ($1000/$1000=1.00). Let's say debt increases to $2,000 due to taking out a loan and equity remains the same. In this case, the debt-to-equity ratio would increase to 2.00, which would suggest that for every dollar of equity, the firm uses twice as much debt to finance operations. As with many ratios, the normal range varies depending on the industry. Capital Intensive industries such as steel foundries and airlines often have high debt to equity ratios because they are generally entering into long-term financing arrangements to acquire revenue producing assets. A word of caution, however, debt-to-equity ratios above 4 to 5 may start to signal high financial leverage, which for many, translates into increased risk in the eyes of creditors and lenders. High financial leverage often carries fixed costs that may be difficult to meet if revenues, margins, and/or expenses move in a negative direction.
Efficiency Ratios:
These ratios are intended to describe how efficiently, or intensively, a firm uses assets to generate sales. One of the most common is the inventory turnover ratio. The inventory turnover ratio is commonly defined as Cost of Goods Sold divided by Inventory (or average inventory). A ratio of 4, for example, tells us that the firm turned over its entire inventory 4 times during the fiscal period being measured. Why is this important? Theoretically, the more a firm turns over its inventory the more cash is being generated. It is also important, especially when compared over multiple periods, in telling the firm whether there may be an inventory management problem such as slow moving SKUs or issues in the purchasing department.
Coupled with the Inventory Turnover Ratio is the Days Sales in Inventory, which is defined as 365 days divided by the Inventory Turnover Ratio. Using our example above of 4, the Days Sales in Inventory Ratio would be 91.25 days (365/4=91.25). This result indicates that on average, the company took 91.25 days to fully turn over its inventory, or conversely, inventory sits for 91.25 before being sold. Generally, the lower the number of days the better as this would indicate the company is converting inventory to cash more frequently thereby generating cash more frequently. Again, comparison with industry norms is the best way to determine whether this area of the business is operating as efficiently as it should be.
Another common efficiency ratio is the Accounts Receivable Turnover Ratio, which is defined as Sales/Accounts Receivable (or average A/R). This ratio tells the company how fast they collect on sales made on credit. If a company demonstrates a ratio of 10, the ratio would indicate that the company collected on outstanding credit and lent the money again 10 times during the year. The meaning of the ratio is more easily understood if put in terms of Days sales in A/R, which is defined as 365/Receivables Turnover Ratio. In our example, the company demonstrates 36.5 A/R days (365/10), which implies the company takes, on average, 36.5 days to collect on its receivables. Like the Days sales in inventory, a lower number is better as it indicates the company is very good at collecting on money that is owed, which thereby increases the amount and frequency in which cash is collected.
Profitability Ratios
Profitability ratios measure how efficiently the company uses its assets and how efficiently the firm manages operations. There are three common ratios; profit margin, return on assets and return on equity. Gross Profit margin is simply calculated as gross profit divided by net income. This ratio can also be calculated as net profit margin (net income/sales) or operating margin (operating profit divided by sales). These ratios tell us how much profit the firm is producing per dollar of sales. For example, if a company generates $1,000,000 in sales and $20,000 the net margin would be 2%, or more generally, generates $.02 of profit for every dollar of sales.
Return on assets (ROA) measures the amount of profit per dollar of assets, and can be defined as net income/total assets (or avg total assets). Using the numbers above, if the company generated net income of $20,000 on assets of $500,000, return on assets would be .04 (or 4%). In this case, the company generates $.04 of profit for every $1 of assets. Consequently, the return on equity (ROE) measure is the same calculation only it places profit in terms of total equity (net income divided by total equity) and measures how the stockholders fared during the year.
It is important to note that I have only outlined some of the more common ratios used by financial managers to measure firm performance. There are many ratios that a company can use, and there are many different variations depending on the source. After working with some of the simpler ratios, like the ones above, a company should work with other ratios to determine which ones are most applicable for their particular business.
A financial manager need not memorize these ratios, but rather, enter them into an excel spreadsheet and calculate them periodically as necessary. Once several periods of data are established trends or "red flags" will start to emerge, which will help pinpoint the areas of the organization that may need attention.
Thursday, January 20, 2011
Are You Adequately Protecting Your Business Against Fraud?
Unfortunately for many businesses, they are all too familiar with the damaging effects fraud can have on their organization. In a 2009 survey conducted by the American Banking Association, it was estimated that industry check-related losses amounted to approximately $1.024 billion. Additionally, a 2010 survey conducted by The Association for Financial Professionals (AFP) reported that 90% of respondents to the survey were victims of check fraud, with 64% suffering financial loss as a result.
It becomes all-too important to take the steps necessary to safeguard you and your business against fraudulent activities that can strike without warning. Increasingly, as we all navigate the recent financial crisis, cost savings has becomes a paramount concern for many enterprises. I would caution many businesses, however, from cutting costs in areas that can have a potentially devastating impact. While many businesses, for example, may complain about high insurance premiums, I would guess that very few would elect to forgo property insurance all together. Thinking in these terms, many businesses should begin to see that fraud protection services provided by their financial institution may be a wise investment given their relatively nominal cost.
There are several simple ways that businesses can safeguard themselves from payment related fraud. Positive Pay, for example, is a tool that compares an organization's check record with those presented for payment or payee names for possible alteration. The lists that are provided to the bank by the customer are then compared to checks that are presented for payment. Any check that doesn't match is flagged for a pay or return decision.
With respect to ACH payments, companies can use debit block and filters to prevent unauthorized transactions.
Single Use Accounts is another way in which companies are safeguarding their credit card information. Single Use Accounts utilize a one-time generated credit card number that is presented to a vendor or merchant for payment. Once the payment is made, the credit card number is no longer valid thereby virtually eliminating the risk that the number is taken down and used maliciously by an unauthorized user.
Aside from bank products, companies can take simple steps within their organization to help reduce the risk of fraudulent activities. Internal control processes such as daily reconciliation and separation of duties, are effective measures especially in concert with similar sound practices by the organization's financial institution.
While it may seem counter-intuitive, the use of online banking platforms may actually increase the security for many organizations as many modern banking systems have sophisticated user entitlement options that can be used to dictate transactional limits, approval authorities, and account viewing privileges. While many believe that online banking presents a new set of risks, online banking in general is very safe. Most banks use high-end encryption, such as 128-bit which is so powerful that the U.S. government currently does not allow the sale of it overseas. Stealing information that is 128-bit encrypted is virtually impossible, however, what you should pay attention to is what is happening while you are online. Depending on the browser you use, you'll either see a closed padlock icon or a key icon in the lower right or left corner of your browser. When you see these, you'll know that your transaction is being encrypted. Additionally, many sophisticated commercial banking online platforms will use secure tokens that allow for the user to input a pin that changes every 30-60 seconds, which is used in conjunction with a unique username and password.
In summary, businesses are wise to consider looking more closely at implementing fraud protection services and more stringent internal controls. The extra time and cost associated with these activities are far outweighed by the potential benefit these activities bring. Not only is fraud growing at a record pace, but the people carrying out these acts are getting more sophisticated in their methods. Businesses can keep themselves safe by staying informed and alert to potential threats. Talking with your financial professional about your concerns is a first step to fighting back.
It becomes all-too important to take the steps necessary to safeguard you and your business against fraudulent activities that can strike without warning. Increasingly, as we all navigate the recent financial crisis, cost savings has becomes a paramount concern for many enterprises. I would caution many businesses, however, from cutting costs in areas that can have a potentially devastating impact. While many businesses, for example, may complain about high insurance premiums, I would guess that very few would elect to forgo property insurance all together. Thinking in these terms, many businesses should begin to see that fraud protection services provided by their financial institution may be a wise investment given their relatively nominal cost.
There are several simple ways that businesses can safeguard themselves from payment related fraud. Positive Pay, for example, is a tool that compares an organization's check record with those presented for payment or payee names for possible alteration. The lists that are provided to the bank by the customer are then compared to checks that are presented for payment. Any check that doesn't match is flagged for a pay or return decision.
With respect to ACH payments, companies can use debit block and filters to prevent unauthorized transactions.
Single Use Accounts is another way in which companies are safeguarding their credit card information. Single Use Accounts utilize a one-time generated credit card number that is presented to a vendor or merchant for payment. Once the payment is made, the credit card number is no longer valid thereby virtually eliminating the risk that the number is taken down and used maliciously by an unauthorized user.
Aside from bank products, companies can take simple steps within their organization to help reduce the risk of fraudulent activities. Internal control processes such as daily reconciliation and separation of duties, are effective measures especially in concert with similar sound practices by the organization's financial institution.
While it may seem counter-intuitive, the use of online banking platforms may actually increase the security for many organizations as many modern banking systems have sophisticated user entitlement options that can be used to dictate transactional limits, approval authorities, and account viewing privileges. While many believe that online banking presents a new set of risks, online banking in general is very safe. Most banks use high-end encryption, such as 128-bit which is so powerful that the U.S. government currently does not allow the sale of it overseas. Stealing information that is 128-bit encrypted is virtually impossible, however, what you should pay attention to is what is happening while you are online. Depending on the browser you use, you'll either see a closed padlock icon or a key icon in the lower right or left corner of your browser. When you see these, you'll know that your transaction is being encrypted. Additionally, many sophisticated commercial banking online platforms will use secure tokens that allow for the user to input a pin that changes every 30-60 seconds, which is used in conjunction with a unique username and password.
In summary, businesses are wise to consider looking more closely at implementing fraud protection services and more stringent internal controls. The extra time and cost associated with these activities are far outweighed by the potential benefit these activities bring. Not only is fraud growing at a record pace, but the people carrying out these acts are getting more sophisticated in their methods. Businesses can keep themselves safe by staying informed and alert to potential threats. Talking with your financial professional about your concerns is a first step to fighting back.
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