Subscribe to our newsletter for monthly tax tips:


Schedule a Free Consultation Learn About Our Services

The Ratios: Which are the Most Important?

Posted on October 9th, 2017

Jack Kern
Owner, President
Outsourced Accounting Department, Inc.

Of course, the short answer to this question is, “they all are.” But there are a couple of calculations I like to look at most, because they capture just about everything else.

The first ratio I like to look at is “Debt Service Coverage.”  Although not all businesses have debt obligations, a common reason for outsiders to request financial statements is to determine how much debt a business can afford to repay. This in turn is first a function of the company’s profitability, as loan payments ultimately must be paid from the company’s cash flow from operations, of which “profit” is a critical component. There are several ways of calculating Debt Service Coverage, but a commonly used formula is as follows:

Earnings Before Interest, Taxes, Depreciation and Amortization (“EBITDA”)
Total Principal + Interest Payments

So based on the above formula for instance, if a company’s Debt Service Coverage Ratio is less than 1:1, say due to the fact that it is incurring (accrual) operating losses, it’s an indication that the company cannot repay its debt obligations out of internally generated operating cash flow (and therefore a reason for its loan request to be denied).

Then taking this a step further, another measure I like to look at is Net Working Capital,  or more precisely, the changes to net working capital from accounting period to accounting period. Although we’re talking here about the company’s current assets and liabilities, an important concept that must be recognized, is that what actually causes a change in Net Working Capital, are changes in the company’s fixed and non-current assets, and its long-term liabilities.

Using the breakeven scenario from one of my recent articles (“What is My Monthly Breakeven Point of Sales?”), this mathematical phenomenon is illustrated below:

Loader Loading...
EAD Logo Taking too long?

Reload Reload document
| Open Open in new tab

The above type of analysis is often shown in audited and reviewed financial statements (which unfortunately these days, small business owners never see as banks are now relying more heavily on tax returns.  But to me, this type of analysis is extremely valuable as it captures the effects on working capital of all of the other financial indicators in one place that I’ve written about, including: profitability and profit margins; growth funding; liquidity and turnover ratios; debt service coverage; and, funds management (i.e., the matching of sources and uses of funds).

For purposes of this article, I have rearranged the traditional format a little to make more clear what’s happening in terms of the sources and uses of funds.  Note how the changes in fixed and long-term sources of working capital are included in the analysis of the working capital components as either a “source” or a “use” of funds.  (Usually, these are shown as a net change at the bottom.)

The point is, in this example, one can more clearly see how operating losses, or any of the other above fixed and long-term financial activities, have a major impact on the business’ short-term working capital position, and possibly as a result, the owner’s personal cash position.


Related Articles:

Profit vs. Cash Flow Revisited: “The Matching Principle”

Analyzing the Components of Cash Flow

Larry’s Debt Repayment Strategies, Inc.

The Effect of Sales Growth on Cash Flow

The Relationship Between Turnover Ratios and Cash Flow



Comments are closed.