Unlocking the Power of Financial Ratios Part One

519 views
0

In 2022, CUSO Magazine published an article on ratios you could use to understand how your credit union was performing. This article discussed key financial ratios to track the credit union’s financial performance. In addition to these credit union ratios, there is an entire set of ratios available to use when evaluating a CUSO’s performance.

While these ratios are not the same as credit union ratios, these business ratios can be very useful in evaluating the financial performance of CUSOs, can help provide a response to NCUA inquiries into the health of a credit union CUSO investment, or in evaluating a CUSO before credit union investment or purchase.

Solvency ratios

Solvency ratios measure the ability of a company to pay long-term debt obligations. Solvency ratios are distinguished from liquidity ratios by the focus on long-term debt obligations as opposed to short-term obligations. Solvency refers to the ability of a company to continue operating in the future.

The Quick Ratio (also known as the Acid Test or Liquid Ratio) is a simple measurement of the ability of a business to cover its current liabilities with those current assets readily convertible to cash (the dollars of liquid assets available to cover each dollar of current debt).  “Quick” refers to the concept that the ratio is only looking at assets that can be quickly converted to cash. Note: as a rule of thumb, liquid assets should include only assets that can be quickly converted to cash within three months.

While there are different formulas used to calculate the Quick Ratio, the most common is Cash plus Accounts Receivable divided by Current Liabilities. If the ratio is 1.0 (or 100%) the business is generally considered to be in a liquid condition. There is no specific desirable number for the quick ratio, but the greater the ratio or percentage, the greater the liquidity.

Figure 1 – Quick Ratio Example

2021 2020 2019
Cash  $          180,000.00  $          180,000.00  $          140,000.00
Accounts Receivable  $            10,000.00  $            10,000.00  $              6,000.00
Current Liabilities  $          180,000.00  $          200,000.00  $          160,000.00
AS A RATIO 1.06 0.95 0.91
AS A PERCENTAGE 106% 95% 91%

In this example, the business starts off in 2019 in a slightly illiquid state. Current cash and accounts receivable are not enough to offset the current liabilities. In 2020, the ratio improved due to an increase in cash and accounts receivable, but not enough to offset the increase in liabilities. By 2021, cash has remained the same but the drop in current liabilities has the business in a liquid condition, with $1.06 available to cover every $1.00 in liabilities.

The Current Ratio is not as conservative as the Quick Ratio, which only reviews items that can be converted to cash quickly. By contrast, the Current Ratio includes inventory and other assets which by their nature may not be as easy to convert to cash. The Current Ratio is calculated as Current Assets divided by Current Liabilities. Because the Current Ratio is less conservative, a ratio of 2.0 is a target that many analysts are looking for when evaluating a business.

Figure 2 – Current Ratio Example

2021 2020 2019
Current Assets  $          200,000.00  $          150,000.00  $          100,000.00
Current Liabilities  $          100,000.00  $          150,000.00  $          200,000.00
AS A RATIO 2.00 1.00 0.50
AS A PERCENTAGE 200% 100% 50%

In the example in Figure 2, the business’s current ratio is improving over a three-year period. That said, a business may wish to reinvest current assets when there is a strong cash inflow. As with all of these ratios, the determination of if the Current Ratio is favorable is subject to considerations outside the actual calculation.

The Current Liabilities to Net Worth Ratio is a measurement of the pressure debt has on future cash flows. The calculation is derived by dividing Current Liabilities by the Current Net Worth. The higher the ratio, the more the company may be relying on equity for payment of debt. Examiners may raise concerns if the percentage is greater than 60% and may be alarmed if the relationship exceeds 80%.

Figure 3 – Current Liabilities to Net Worth Ratio Example

2021 2020 2019
Current Liabilities  $          40,000.00  $          60,000.00  $          80,000.00
Net Worth  $          100,000.00  $          100,000.00  $          100,000.00
AS A RATIO 0.40 0.60 0.80
AS A PERCENTAGE 40% 60% 80%

Because this ratio indicates the amount due to creditors as a percentage of the owner’s investment, the example above in Figure 3 suggests that the company’s ownership value is at risk in 2019 and 2020. Put another way, the measurement shows the funds creditors are risking in a year against the funds permanently invested by its owners. In 2021, the ratio indicated significantly less risk.

The Debt-to-Equity Ratio (or Total Liabilities to Net Worth Ratio) contrasts with the Current Liabilities to Net Worth Ratio by measuring the relative size of long-term debt. As a general statement, if total liabilities exceed net worth, creditors have more stake in the company than the owners. The Debt-to-Equity Ratio is calculated by dividing Total Liabilities by Net Worth.

Figure 4 – Debt-to-Equity Ratio Example

2021 2020 2019
Total Liabilities  $          60,000.00  $          110,000.00  $          180,000.00
Net Worth  $          100,000.00  $          100,000.00  $          100,000.00
AS A RATIO 0.60 1.10 1.80
AS A PERCENTAGE 60% 110% 180%

With respect to the above example in Figure 4, in 2019 the company may be a riskier investment because the company has taken on debt to leverage its assets which often means its growth was financed with liabilities. At the very least, an investor should understand whether a company with a high ratio has a plan for managing its long-term debt obligations. Reviewing trends may be important as certain components, such as retained earnings, may distort the ratio in any given year.

Fixed Assets to Net Worth Ratio (or Non-Current Assets to Net Worth Ratio) reveals how much equity is tied up in the form of fixed assets such as property or equipment. The ratio is calculated by dividing Fixed Assets by the Net Worth of the company. As a general rule, examiners and investors may become concerned if the percentage is over 75% because it indicates that the company may be more vulnerable to business climate changes or disasters.

Figure 5 – Fixed Assets to Net Worth Ratio Example

2021 2020 2019
Fixed Assets  $          100,000.00  $          150,000.00  $          250,000.00
Net Worth  $          300,000.00  $          300,000.00  $          300,000.00
AS A RATIO 0.33 0.50 0.83
AS A PERCENTAGE 33% 50% 83%

In the above example in Figure 5, 2019 working capital could be frozen in the form of equipment with a corresponding risk that the margin for operating funds may be too narrow to support operations. The company should ensure there is a plan for business disruptions.

Efficiency Ratios

While the solvency ratios determine to a certain extent the risk a company may face in paying its debts, efficiency ratios are designed to provide insight as to how a company uses its assets to generate income. Not all of these ratios may be applicable to a particular CUSO or particular business.

The Collection Period Ratio or Average Collection Period provides insight into how quickly a company’s clients pay their bills. The ratio is calculated by dividing Accounts Receivable for the Time Period by Net Sales times the number of days used for the review (such as 365 days).

Figure 6 – Collection Period Ratio Example

2021 2020 2019
Accounts Receivable  $          25,000.00  $          10,000.00  $          10,000.00
Net Sales  $          900,000.00  $          50,000.00  $          100,000.00
Days 365 365 365
AVERAGE COLLECTION 10.1 Days 73.0 Days 36.5 Days

As a general rule, a lower collection period is preferred over a higher one as a lower collection period indicates a company can increase its cash supply faster. However, a downside to a lower collection period is that the company’s terms may be so strict that customers will go to competitors who have more lenient terms. This calculation is best used with a holistic view of the company’s financials, including its ability to pay its creditors.

The Asset to Sales ratio is a sales calculation that asks how efficiently a company is leveraging assets to generate sales to make those assets worthwhile. The calculation is generated simply by taking Total Assets and dividing them by Net Sales.

Figure 7 – Assets to Sales Ratio Example

2021 2020 2019
Total Assets  $          100,000.00  $          100,000.00  $          100,000.00
Net Sales  $          80,000.00  $          50,000.00  $          200,000.00
AS A RATIO 1.25 2.00 0.5
AS A PERCENTAGE 125% 200% 50%

For the example above in Figure 7, the 2019 ratio of 50% may indicate the business is selling more than can be safely covered by its assets. In 2020, the high percentage may suggest the business is not aggressive enough in its sales, or that its assets are not being employed correctly.  The 2021 ratio is generally considered to be a healthy asset to sales ratio. Of course, there may extenuating circumstances that can explain an abnormally high or low ratio, including expansion to a new facility.

A ratio that can be used in conjunction with the Asset to Sales ratio is the Sales to Net Working Capital Ratio. This ratio measures how effective a business is at generating sales for every dollar of working capital and is calculated by taking Net Sales and dividing it by Working Capital (Current Assets minus Current Liabilities).

Figure 8 – Sales to Net Working Capital Ratio Example

2021 2020 2019
Net Sales  $          120,000.00  $          120,000.00  $          120,000.00
Current Assets  $          30,000.00  $          10,000.00  $          100,000.00
Current Liabilities  $          10,000.00  $          5,000.00  $          10,000.00
AS A RATIO 6.00 24.00 1.33
AS A DOLLAR AMOUNT $6.00 $24.00 $1.33

In 2019, the company is only generating $1.33 in sales from its working capital. That number is low and suggests the company may not be efficiently utilizing its working capital. In 2020, the company has a very high working capital ratio, which is normally a good thing. However, it may also indicate the company will need to raise additional capital to support future growth. The 2021 ratio suggests that the company has a good balance in using its working capital to generate sales.

To be continued

While there are plenty more ratios for us to go over, we will do so in part two of this series. Until then, get to know these ratios a little better and learn where they might help you out, whether it be in board reports, inquiries, or investment opportunities. Have any questions? Post them in the comments below!

Authors

  • Bob Frizzle

    CFO, CU*Answers. Formerly Chief Financial Officer of a credit union in Virginia, Mr. Frizzle has been involved in the credit union industry since 1988. Mr. Frizzle has served as CU*Answers CFO since joining the 100% credit union-owned cooperative Credit Union Service Organization (CUSO) in 1997. Mr. Frizzle also provides accounting and CFO services to numerous national organizations and CUSOs. These include Xtend, Inc., eDOC Innovations, NACUSO, CU Student Choice, CU*NorthWest, and Chatter Yak. He is an active board member for eDOC Innovations.

  • Patrick Sickels

    Internal Auditor, CU*Answers

  • Christen Lipschutz

    Internal Auditor, CU*Answers

Your email address will not be published. Required fields are marked *