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What do Creditors Really Want?


5/1/2005
By Gary Naples

 

At some point, the majority of parts store owners have to secure funding in the form of loans from creditors. Whether it's necessary for more inventory, store upgrading or expanding operations, how the creditor views your business determines the outcome of the financing you seek.

Unlike the focus of the parts store, which is directed toward the company as an ongoing concern, the focus of the creditors' viewpoint is divided. The creditors' interest lies in the following two areas:

 

  • The funding of a successful business.
  •  

  • Keeping a cautious eye toward the possibility of default.
  •  

Creditors have no "stake" in the business other than regular interest and principal payments. Therefore, creditors must carefully assess the risk involved for recovering loaned funds. Most information used by creditors comes from the balance sheet, although the income statement is used for some calculations.

Why is it important to understand the creditors' point of view? As I said previously, at some point you'll seek funding as a normal course of business. Knowing what to expect from creditors will help you better prepare when the time comes to look to outside sources for financing. Moreover, understanding the liquidity and financial performance ratios used by creditors also will facilitate the financial management skills of the parts operations owner or manager. Good business decisions and a successful operation rely on thorough financial knowledge combined with trade experience.

One of the most common ratios used is widely known as the "current ratio". This ratio is one test of solvency, measuring the liquid assets available to meet all debts falling due within one year.

Generally, the rule of thumb is to maintain a current ratio of at least 2:1 or close to it, for the sake of sound cash flow and healthy financial condition. This will allow shrinkage of up to 50 percent in the value of current assets and still cover the current liabilities. However, a 2:1 ratio is not necessarily a must, particularly if a major part of the current assets is in cash and readily collectable receivables. Otherwise, 2:1 or better is a good idea.

From the creditors' viewpoint, a higher current ratio certainly would appear to protect his or her claim against liquidation. On the surface, this translates into a better position for the debt holders because of the sizeable cushion of assets. However, when viewed from another angle, an excessively high current ratio could indicate poor management practices due to bloated inventories with excessive supply, and poor financial management in terms of aging and overextended accounts receivables.

Another common measure of liquidity used is the "quick ratio," also called the acid test (see page 76). This is a more stringent test, which uses only a portion of the current assets for calculation - cash (including marketable securities) and accounts receivable.

The idea behind this ratio is to test the ability to collect current liabilities should a real crisis occur, assuming that no value will remain in inventories. The rule of thumb for quick ratio should be 1.0.

One final caution about rule-of-thumb ratios: They are far from infallible. Results are influenced by the date on which the balance sheet is drawn, as well as by the kind of business you operate. This ratio should be compared to the industry standard for your business, as creditors will surely do.

From a standpoint of business disaster, current ratio and quick ratio are useful in assessing the ability to pay. Nevertheless, they are only a small part of the analysis. For a more overall view of the level of risk of the business, creditors are likely to employ a variety of ratios measuring debt to various parts of the balance sheet.

An important ratio of this group is debt to equity, also known as total debt to tangible net worth (see page 76). This ratio measures what is owed to what is owned.

Any debt is risky; therefore, beware of top-heavy liabilities! If nothing else, those liabilities undermine sound business judgment. Parts store owners and owner/managers of parts operations who are worried about finding money are less likely to have the analytical objectivity needed for planning sound business programs.

HOW MUCH?
How much can a business afford to owe? The question is rather academic because the answer depends on the type of business and what is financed. A parts operation generally has most of its current assets in inventory, which must be sold to realize cash. A heavily obligated parts store or parts operation may find a sudden drop in inventory turnover quite damaging. Again, industry comparisons should be made for your type of business.

TIMES INTEREST EARNED
The last ratio to be aware of, from the creditors' viewpoint, is times interest earned (see page 76). This ratio examines the relationship of net profit before taxes and interest to the actual interest payments. The disclosure of this ratio is in the hope that the annual operating profit will provide a basic source of funds to service debt. No rule of thumb exists for this ratio. However, it is generally accepted that if this ratio falls below 1.0, the business is not generating enough earnings to cover the interest on loans due. Unlike the previous calculations, which draw their information from the balance sheet, the source of information for this ratio is the income statement.

Now, to a degree, you can conduct an analysis of your parts operation from a creditors' viewpoint. This will give you the opportunity, if necessary, to correct any deficiencies or improve any performance areas. At the very least you should have a better understanding of how your business is viewed from a creditor or lender's perspective. Hopefully, when it comes time to secure funding from an outside source you'll be in a good position to obtain it.

Writer Gary J. Naples provides automotive parts consulting and training services through Freelance Associates, Inc. He is the author of two books on automotive parts management published by SAE International: By the Numbers: Principles of Automotive Parts Management and Beyond the Numbers: Managing the Assets of an Automobile Parts Business. Gary's books can be purchased directly from the publisher online at www.sae.org, or by calling 724-776-4841. Gary can be reached at 570-824-1528 or email at freelanceassoc@aol.com.

 

Figuring the Formulas

Current Ratio = Current Assets from Balance Sheet / Current Liabilities from Balance Sheet
Example:
$312,040
$95,987 = 3.25 times

Quick Ratio (Acid Test) = Cash + Accounts Receivable from Balance Sheet / Current Liabilities from Balance Sheet
Example:
$88,060
$95,987 = 0.9 times

Debt to Equity = [Total Liabilities (Current Debt + Long-Term Debt) / Net Worth] x 100
Example:
$143,712
$199,328 = 0.72 x 100 = 72%

Time Interest Earned = Net Profit Before Taxes + Interest / Interest
Example:
$11,987
$3,425 = 3.49















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