Business Assessment Ratios: A Cheat Sheet

The pandemic resulting from the coronavirus has affected business scenario across the globe. In India, the MSME sector ranks high among those impacted by extreme circumstances.

Some of the business ratios, their implications and ways to improve are provided below to create a cheat sheet that MSMEs can use as a ready reference:

1. The Quick Ratio

The Quick Ratio measures the ability of a business to pay its short-term liabilities by having assets that can be readily converted into cash. It is also known as the Acid-test or Liquidity ratio. The assets that are taken into consideration are – cash, marketable securities and accounts receivable.

Implication: If the ratio is above 1, then it indicates that a business has enough cash or cash equivalents to cover its short-term financial obligations and sustain its operations.

Ways to improve: A business needs to reduce the inventory and prepaid expenses and also the current liabilities and always ensure that the company’s liquidity is more than 1. The quick ratio is an indicator of a company’s capability and ability to pay its current obligations.

2. Debt to Equity Ratio

The debt-to-equity ratio is an example of leverage ratio. It calculates the weight of total debt and financial liabilities against total shareholders’ equity. It is also referred to as the “debt-equity ratio”, “risk ratio”, or “gearing”. The D/E ratio uses total equity. This ratio highlights how a company’s capital structure is inclined towards debt or equity financing.

Implications: A higher debt-equity ratio indicates a levered firm or a company that is stable with significant cash flow generation, but not preferable when a company is in decline. Contrarily, a lower ratio indicates a firm less levered, and it shows that the firm is closer to being fully equity financed.

Ways to improve: The appropriate debt to equity ratio is not fixed and varies by industry.

A high debt-equity ratio implies good condition as it shows that a firm can easily service its debt obligations (through cash flow) and is using the leverage to increase equity returns.

Also, typically the value of debt is lower than the value of equity. So, increasing the D/E ratio (up to a certain point) results in a lower weighted average cost of capital (WACC) for the firm.

3. Cash Conversion Cycle Ratio

The Cash Conversion Cycle (CCC) is a metric that indicates the amount of time a company would take to convert its investments in inventory to cash. The conversion cycle formula measures the quantity of your time, in days, it takes for a company to show its resource inputs into cash.

Implications: The cash conversion cycle formula is an important metric to assess how efficiently a company is managing its working capital. As with other cash flow calculations, the shorter the cash conversion cycle, the better the company’s financial health at selling inventories and recovering cash from these sales while paying suppliers.

Ways to improve: The cash conversion cycle should be compared to companies operating in the same industry and conducted on a trend. For example, measuring a company’s conversion cycle to its cycles in previous years can help with gauging whether its working capital management is declining or improving. Also, a comparison of the company with its competitors helps in determining whether the company’s cash conversion cycle is “normal” compared to industry competitors.

The above business assessment ratios are the best ratios for MSMEs to create a cheat sheet as a ready reference to determine their financial health. Businesses need to create the best and worst-case scenarios depending on their industry condition and take the right decision at the right time.