Trend Analysis—Long-Term Debt-Paying Ability

Posted by PITHOCRATES - January 28th, 2013

Economics 101

To Help with the Decision Making Process Small Business Owners look at Past Results and Trends

A small business owner has a lot on his or her mind.  Most of which have something to do with cash.  If they will have enough for their short-term needs.  And their long-term needs.  Because if they don’t there’s a good chance he or she will be a small business owner no more.  So with every decision a small business owner makes he or she asks this question.  What will be the cash-impact of this decision?  Both short-term.  And long-term.

To help with this decision making process small business owners look at past results.  And the trend between accounting periods.  Either quarterly.  Or monthly.  For there is a lot more to a business’ health than net profit.  Or cash in the bank.  You can have neither and still be a healthy business.  And you can have both and be in a lot of danger.  Because these are only parts of the bigger picture.  It’s how they fit together with the other pieces that give small business owners useful information.  So let’s take a look at 4 quarters of fictitious data.  And what the data trends tell us.

Trend Analysis Long-Term Debt

Looking at these numbers you can arrive at different conclusions.  Sales were 1.7 million or higher for all 4 quarters.  That seems good.  But sales fell the last two quarters.  That seems bad.  But it’s hard to get a full grasp of what these numbers can tell us on their own.  But if we look at some ratios we can glean a lot more information.  And can graph these ratios and look at trends.

If the Debt Ratio is less than 1 it means the Business is Insolvent

If you divide current assets (Cash through Inventory) by current liabilities (Accounts Payable through Current Portion of L/T Debt) you get the current ratio.  A liquidity ratio.  Telling a small business owner his or her short-term (in the next 12 months) cash health.  If this ratio is greater than one than you have more current assets than current liabilities.  Meaning you should be able to meet your cash needs in the next 12 months.  Which is good.  If it’s less than 1 it means you may not be able to meet your cash needs in the next 12 months.  Which is bad.  But is there a ‘correct’ number for a small business?  No.  It could vary greatly depending on the nature of your business.  But the trend of the current ratio can provide valuable information.

Trend Analysis Long-Term Debt Current Ratio

This business became more liquid from Q1 to Q2.  Meaning they should have been able to meet their short-term cash needs even easier in Q2 than Q1.  A good thing.  But they became less liquid from Q2 to Q3.  With their current ratio falling below 1.  Meaning they may not have had enough cash to meet their short-term cash needs.  Their short-term cash position improved in Q4.  But it was still below one.  So the current ratio trend for these 4 quarters shows a cause for concern.  Is it a problem?  It depends on the big picture.  So let’s look at more parts that make up the big picture.

Plotted on the same graph is a long-term debt-paying ability ratio.  The debt ratio.  Which we get by dividing Total Assets by Total Liabilities.  If this number is less than 1 it means Total Assets are greater than Total Liabilities.  Which is good.  If it’s greater than 1 it means the business is insolvent.  Which is bad.  As insolvency leads to bankruptcy.  The trend from Q1 to Q2 was good.  Their debt ratio fell.  But it rose between Q2 and Q3.  Rising above 1.  Which is a great cause for concern.  It fell between Q3 and Q4 but it was still below one.  Is this a problem?  It’s starting to look like it is.

There is no such thing as a Sure Thing for a Small Business Owner

Are they going to have trouble servicing their debt?  There are ratios for this, too.  Such as the Times Interest Earned (TIE).  Which shows how many times your recurring earnings can pay your interest costs.  In this example we have normal interest expense such as that paid on the business line of credit.  And the capitalized interest such as the interest portion on a car payment.  We calculate TIE by dividing recurring earnings by total interest expenses.

Trend Analysis Long-Term Debt Times Interest Earned

In Q1 their recurring earnings had no trouble covering their interest expenses.  In Q2 recurring earnings grew as did their ability to pay their interest expenses.  But the trend following Q2 has been downward.  Either indicating a surge in debt.  And interest due on that debt.  Or a fall in recurring earnings.  In this case it was a fall in earnings.  Which plummeted following Q2.  Looking at another ratio we can see the extent of these poor earnings on their long-term debt-paying ability.  If we divide Total Liabilities by Owner’s Equity we get the debt to equity ratio.  If this number is 1 then the business is financed equally by debt and equity.  If it’s less than 1 more equity (typically produced by recurring earnings) than debt financed the business.  Which is preferable as equity financing doesn’t incur any costs or risk.  If it’s greater than 1 it means more debt than equity financed the business.  Which is not as preferable.  Because debt-financing incurs costs.  As in interest expense.  And risk.  The greater the debt the greater the interest.  And the greater risk that they may not be able to repay their debt.  Which could lead to bankruptcy.

Trend Analysis Long-Term Debt Debt to Equity Ratio

This business was highly leveraged in Q1.  With virtually all financing coming from debt.  Probably because the owner drew a lot of money out during some profitable years.  Something banks don’t like seeing.  They like to see the owner sharing the risk with the bank.  If they don’t it can be a problem if the business owner wants to borrow money.  Which this one did in Q3.  Because business was doing so well this owner wanted to expand the business by adding another piece of production equipment.  But being so highly leveraged the owner had to put up a sizeable down-payment to get a loan for this new piece of production equipment.  As can be seen by the $20,000 owner contribution in Q3.  There was also a large decline in Owner’s Equity in Q3.  Indicating a one-time charge or correction.  With the loan the owner increased production.  And was looking forward to making a lot of money.  Which was not to happen.  For the economy fell into recession in Q3.

Sales fell just as they increased production.  Which led to a swelling inventory of unsold goods.  Worse, the recession was hurting everyone.  As can be seen by the growth in accounts receivable.  Because people were paying them slower they were paying their suppliers slower.  As is evident by the growth in their accounts payable.  Then a piece of equipment broke down.  They had no choice but to replace it.  Requiring another equity infusion of $10,000.  While some write-downs of bad debt reduced Owner’s Equity further.  (Or something similar.  With such low recurring profits by the time you add in other one-time and non-recurring costs this can lead to a net loss.  And a decline in Owner’s Equity.)  Despite this $30,000 equity infusion into the business the debt to equity ratio soared between Q3 and Q4.  Showing how poorly recurring operations were able to generate cash after that expansion in Q3.  Which explains their insolvency.  And as leveraged as they are it is very unlikely that they are going to be able to borrow money to help with their pressing cash needs.  Meaning that the decision to expand in Q3 may very well lead to bankruptcy.

This is just an example of the myriad concerns a small business owner has to consider before making a decision.  And a successful small business owner always has to factor in the possibility of a recession.  It’s not for the faint of heart.  Being a small business owner.  For it’s a lot like gambling.  There is just no such thing as a sure thing.

www.PITHOCRATES.com

Share

Tags: , , , , , , , , , , , , , , , , , , , , , , , , , , , , ,

Comments are closed.

Blog Home