By: Mary Ellen Biery, Research Specialist, Sageworks, Inc.
A recent study found that while nearly 91 percent of private-company owners were enthusiastic about executing growth strategies, only 51 percent reported having the necessary financial resources to do so. Furthermore, the study by Pepperdine University found that banks reported they were declining, on average, 36 percent of loan applications, with quality of earnings and/or cash flow as the most common reason (32 percent).
In other words, many private companies are finding it challenging to access financial resources for growth at a time when lenders are still cautious and facing pressure to avoid risky loans.
So what should a business that needs to borrow do?
One option is to focus on improving the financial metrics that can best predict loan default – the exact scenario banks want to avoid. The following are the five key financial variables that are the best predictors of default and how to improve them:
Cash to Assets
The Cash-Assets ratio is a key measure of liquidity and one of several coverage ratios that indicate a company’s likelihood of default.
One way to increase the cash to assets ratio is to lower accounts receivables. This can start with an examination of the company’s credit policy to make sure its credit practices are increasing revenue. Another way to ensure a high ratio is to implement a system that allows the business to order inventory only when needed.
More Ways to Improve Cash-Assets Ratio:
• Consider limiting on-credit purchases
• Monitor invoicing procedures to limit late collections
• Avoid pre-paying expenses
EBITDA to Assets
EBITDA, or earnings before interest, taxes, depreciation and amortization, is used to measure a firm’s ability to generate income. Comparing EBITDA to a company’s assets helps show how much income, or cash, a company can generate from its assets, according to Lawrence Litowitz, a partner at strategic advisory firm SCA Group LLC.
Boosting EBITDA is one way to increase this ratio; it involves either raising revenues or cutting expenses. Raising revenues can involve improving business offerings by gaining insight from customers through market research. Businesses that are willing to negotiate with providers may also be able to trim expenses, directly impacting the bottom line, and improving EBITDA.
Debt Service Coverage Ratio
The Debt Service Coverage Ratio, EBITDA divided by the current portion of long-term debt and interest expense, is an important metric for predicting default. More than two-thirds of the financial institutions in the Pepperdine survey said this statistic was important or very important in their lending decisions.
One effective way of tackling the debt/interest side of this ratio is to cut expenses (e.g., overhead expenses) and apply the savings toward paying off the principal.
More Ways to Improve Debt Service Coverage Ratio:
• Consider refinancing to lower interest rates
• Decrease interest payments by using current cash to pay off the principal
Liabilities to Assets
The Liabilities-Assets ratio shows how much of a company’s assets are financed through debt. Financial institutions want this ratio to be as low as possible. “The more debt you have, the more of your cash flow you’ve committed to supporting that debt,” notes M. Cary Collins, director of the Global Entrepreneurship Program and associate professor of finance at Bryant University.
Improving this ratio is all about reducing debt. The Better Business Bureau recommends that businesses make the highest possible debt payment each month, especially on credit cards.
Net Income to Sales
Another metric used to predict default is the Net Income-Sales ratio, which measures profitability and efficiency. There are three possible ways to increase profitability, according to the book, Financial Intelligence for Entrepreneurs. One option – cutting operating expenses – can be a short-term fix. The other two ways – lowering production costs and increasing profitable sales – are likely better choices but take time to identify and implement.
Lowering production costs involves attaining cheaper raw materials and key services or identifying more efficient methods of producing a good or providing a service.
To increase sales, “You have to find new markets or new prospects, work through the sales cycle, and so on,” according to the book’s authors, Karen Berman and Joe Knight.
More Ways to Improve Net Income to Sales Ratio:
• Increase sales volume by scheduling operational duties (such as receiving) to take place at a time customers aren’t likely to need assistance.
• Seek customer feedback as to how to optimize customer offerings and identify new markets
The last thing a business owner wants is to need credit and to agonize over whether the business will qualify. Improving key financial metrics of importance to lenders can improve a firm’s appeal to banks and other potential creditors.
Mary Ellen Biery is a research specialist at Sageworks, a financial information company and provider of the Business Credit Report by Sageworks. She is a veteran financial reporter whose works have appeared in The Wall Street Journal and on Dow Jones Newswires, CNN.com, MarketWatch.com, CNBC.com, and other sites.