Could Your Next Business Loan Get “Ratio’d?”

We live and work in an era of big data. Banks are active participants, keeping a keen eye on metrics that help them accurately estimate risk of default.

As you look for a loan, try to find out how each bank will evaluate your default probability. Many do so using spreadsheets that track multiple financial ratios. When one of these key ratios goes askew, a red flag goes up on their end — and the loan may be denied.

Common metrics

To avoid getting “ratio’d” in this manner, business owners should familiarize themselves with some of the more common metrics that banks use to gauge creditworthiness.

For example, banks will compare cash and receivables to current liabilities. If this ratio starts slipping, you’ll likely need to push accounts receivable so money comes in more quickly or better manage inventory to keep cash flow moving. Other examples of financial benchmarks include:

  • Gross margin [(revenue – cost of sales) / revenue],
  • Current ratio (current assets / current liabilities),
  • Total asset turnover ratio (annual revenue / total assets), and
  • Interest coverage ratio (earnings before interest and taxes / interest expense).

Some banks may also calculate company- or industry-specific performance metrics. For instance, a warehouse might report daily shipments or inventory turnover, not just total asset turnover. Meanwhile, a retailer might provide sales graphs that highlight product mixes, sales rep performance, daily units sold and variances over the same week’s sales from the previous year.

Other methods

Bear in mind that not every bank uses ratios to evaluate performance, or they may combine ratio analysis with other benchmarking tools. Some use community-based scoring, by which a selected group of finance professionals rate and review companies based on their payment histories. Others use proprietary commercial-scoring models that use creditor reports to develop credit scores for businesses.

Preventing disappointment

When a strategic initiative fails to launch because your business can’t obtain financing, it can be crushing. To prevent such disappointment, have your financials in order and target as many common ratios as possible. Please contact our firm for help evaluating your performance and determining where you may need to improve to obtain a loan.

Use Benchmarking to Swim with the Big Fish

You may keep a wary eye on your competitors, but sometimes it helps to look just a little bit deeper. Even if you’re a big fish in your pond, someone a little bigger may be swimming up just beneath you. Being successful means not just being aware of these competitors, but also knowing their approaches and results.

And that’s where benchmarking comes in. By comparing your company with the leading competition, you can identify weaknesses in your business processes, set goals to correct these problems, and keep a constant eye on how your company is doing. In short, benchmarking can help your company grow more successful.

Two basic methods

The two basic benchmarking methods are:

  1. Quantitative benchmarking:  This compares performance results in terms of key performance indicators (formulas or ratios) in areas such as production, marketing, sales, market share and overall financials.
  2. Qualitative benchmarking:  Here you compare operating practices — such as production techniques, quality of products or services, training methods, and morale — without regard to results.

You can break down each of these basic methods into more specific methods, defined by how the comparisons are made. For example, internal benchmarking compares similar operations and disseminates best practices within your organization, while competitive benchmarking compares processes and methods with those of your direct competitors.

Waters, familiar and new

The specifics of any benchmarking effort will very much depend on your company’s industry, size, and product or service selection, as well as the state of your current market. Nonetheless, by watching how others navigate the currents, you can learn to swim faster and more skillfully in familiar waters. And, as your success grows, you may even identify optimal opportunities to plunge into new bodies of water.

For more information on this topic, or other profit-enhancement ideas, please contact our firm. We would welcome the opportunity to help you benchmark your way to greater success.