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MANAGING CREDIT RATIOS How good is your credit rating? For individuals, creditors usually look at your credit score to assess your credit. For businesses, in addition to business credit scores, credit underwriters often look at a variety of business ratios to determine your creditworthiness. These ratios are also an excellent way for business owners to assess how effective they have been in managing the use of credit.
Debt Service Ratio
One of the most common ratios lenders review is your debt service-to-income ratio. Creditors look at your business’s debt service-to-income ratio to determine whether you are creditworthy for a mortgage, car lease, charge account or any kind of loan.
The debt service ratio is the percentage you get when fixed monthly payment obligations on debts (such as bank loans and credit cards) is divided by gross monthly income. For example, if monthly obligations to creditors total $10,000 and your gross monthly income is $30,000, then your business’s debt service-to-income ratio is $10,000 divided by $30,000, or 33%.
| Debt service ratio example |
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| Monthly payments to creditors |
$10,000 = 33% debt service ratio |
| Gross monthly income |
$30,000 |
Most experts say that your debt service ratio should be 36% or less of your gross monthly income. “Or less” are the operative words. The less debt you incur as a business owner, the better.
Why is it important to stay on top of your debt service-to-income ratio? Because it can help you avoid what credit counselors term “creeping indebtedness,” or the gradual rising of debt. One way to take charge of your debt service ratio is by keeping track of how much money you are spending on credit each month. If your ratio is getting too high, you may need to delay purchases made on credit until the ratio comes back in line.
Current Ratio
The current ratio compares your current assets (everything you own and can easily liquidate, such as money in the bank or short-term debt like treasury bills) to everything you owe short-term—payments that have to be made within the coming year. Potential creditors use this ratio to measure a company's liquidity, or ability to pay off short-term debts. The current ratio is important if you’re thinking of borrowing or asking for terms from one of your suppliers.
| Current ratio example |
|
| Current assets |
$100,000 = 2 current ratio |
| Current liabilities |
$50,000 |
A good current ratio should always be at least 2, i.e., you should have twice as many assets as liabilities. You should look at the current ratio year-over-year to see if your financial picture is improving and why the ratio is changing. If the ratio goes down, you may be heading toward financial problems and should start cutting back on borrowing.
Quick Ratio
The quick ratio measures how liquid your business is, or how easily you can raise immediate cash by selling your assets (thus liquefying them). Potential lenders are often interested in your quick ratio because it shows if you can pay your debt if the worst happens. Because it’s a worst-case ratio, inventory is deducted from your current assets before making the calculation because lenders feel that inventory may be difficult to sell quickly.
The quick ratio is determined by dividing the value of your company’s current assets less inventory by current liabilities (what you owe, from loan payments to payroll taxes).
| Quick ratio example |
|
| Current assets |
$100,000 |
| Less inventory |
$30,000 |
| Balance |
$70,000 = 1:1 quick ratio |
| Divided by liabilities |
$70,000 |
As a rule of thumb, your quick ratio should be at least 1:1. This means that you have $1 in convertible assets for every dollar of current liabilities. You should monitor your quick ratio. Significant changes that bring the ratio below 1:1 can show that you are taking on more debt than you can safely afford to pay back.
Debt-to-Asset Ratio
The debt-to-asset ratio shows how much of your business’s assets (everything from desks to office space) have been acquired by borrowed money, i.e., debt, instead of being purchased with profits from the business or investment by the owner(s). You want to keep your debt-to-asset ratio below 1:1.
| Debt-to-asset ratio example |
| Total liabilities |
$20,000 |
= 20% debt-to-asset ratio |
| Total assets |
$100,000 |
As a rule of thumb, creditors want this ratio to be as low as possible. If you can keep it as low as 20%, creditors would view this favorably because this would mean that only 20% of your business is financed by debt. Creditors feel secure with a low ratio because if times get tough, you won't be struggling to repay your debt to keep your business afloat.
If you have a high debt-to-asset ratio, you may have trouble borrowing or may be forced to pay a much higher interest rate on loans or credit cards.
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