Businesses come in all shapes and sizes, and that’s a good thing. However, there are some business fundamentals that apply across the entire business landscape. The most measureable aspect of any business is its financial disposition (solvency). Your company or business can be most accurately evaluated by taking a look at its financials; more specifically, its financial ratios.
Yes – there are some key financial ratios that financial lending institutions look at in determining a business’s financial disposition or solvency.
Now before we go any further it is important that you have a clear appreciation for what solvency is. Simply stated, solvency is the ability to pay all debt and still conduct day to day operations.
When looking at your business’s short-term solvency, there are several ratios worth looking at; the Current Ratio and Quick Ratio.
Current Ratio: Current Assets/Current Liabilities. This ratio is an excellent diagnostic tool for assessing how healthy your company is when it comes to handling financial obligations over the course of the year of less. (Should be at least equal to at least 1; the higher the better). Where do you get the current assets and current liabilities data? From the company’s balance sheet.
Quick Ratio (also referred to as the Acid-Test Ratio): Current Assets – Inventory/Current Liabilities This ratio is very similar in purpose to the current ratio except it eliminates inventory from the mix and only deals with you more liquid assets such as cash-on-hand. All quick ratio information is gleamed from the balance sheet. The term Acid-Test is derived from the use of acid to determine real gold from false (fouls) gold.
When looking at your business’s long-term solvency (financial leverage), the best ratio to look at is the Total Debt Ratio.
Total Debt Ratio: Total Debt/Total Assets. This ratio shows how much your company or business is in debt. (Should be less than 1; the lower the better. Anything above 1is considered financially unhealthy). Where do you get the Total Debt and Total Assets data from? The company’s balance sheet.
So there you have it. Now you can quickly determine the financial health (solvency) of your company simply by calculating its Current, Quick and Total Debt ratios.
- Essentials of Corporate Finance, 6th Edition; Stephen Ross, et al. McGraw-Hill, 2008.