Financial Ratio Evaluations
Determining the ratio level of a company is a predictor of failure for small businesses, and obtaining data can be difficult. Financial ratios are effective for comparing different types of financial information. Short-term solvency financial ratios should be examined to determine whether a small business is an ideal business for a loan. Short-term solvency measures the company’s ability to meet its financial obligations by providing details about the company’s liquidity measures. Short-term solvency analyzes the company’s assets from cash, stress level, and ability to pay back its loan within the coming year.
Small Business Ratio
Of the short-term solvency, the current ratio is most important. A higher current ratio indicates a positive working capital, and there is a correlation between the current ratio and business size. The higher the current ratio, the more likely the company will be profitable the following year. In addition to current ratio, quick ratio could help in determining whether a business has the ability to meet its obligations. Quick ratio analyzes whether the company has assets in inventory and then deducts the valuation of those items to determine the true value of the organizations assets.
Additional information to obtain from the business owner before making a decision about a loan would be to check the market value and the company’s debt. Analyzing the business ratio to the ratio value of businesses within the same industry can be a predictor of business failure. Determining the debt of the company would help determine the risks level of the company. Debt has a negative effect on a company’s performance. A company with a large amount of debt would generate a high risk of insolvency and potential financial distress.
Large Business Ratio
If a larger company were to ask for a loan, instead of using short-term solvency, I would use long-term solvency considering it focuses on the capital structure and earning power. Long-term solvency is the ability to assure lenders with periodic payments of interest and repayment on the maturity of the loan. It also measures the company’s long-term ability to resolve its loans.
Earnings are better than cash flows for measuring firm value. However, small and unprofitable companies often value cash flows over earnings. As an investor, predictable earnings would be ideal considering they give a sense of how much profit will be paid versus what will be reinvested. In an attempt to avoid negative earnings, CFOs equate the idea of smooth earnings. In a 2003 study, 86.3 percent of nearly 3,200 financial executives stated that maintaining and increasing the company’s stock price helps to build credibility within the capital market as well as attract investors. In regards to meeting financial earnings target, several interviewed CFOs mentioned that they often made economic sacrifices in an attempt to deliver expected earnings. The results of the survey conclude that a majority of companies will sacrifice long-run value for short-run earnings due to market pressures.
If CEO’s have high stock options the firm is less likely to report fraudulent finances. Stock options with incentives can make moral hazard facing CEOs worse. Self-interested CEOs with opportunity to fraud, will likely harm shareholders. Executives with large stockholdings reduce the likelihood of fraud. Industry and firm characteristics are key factors that may affect fraudulent financial reporting. Industry characteristic and firm size are important organizational variations that influence white-collar crime. Principal-agent theory suggests that an increase in CEO options decreases the likelihood of fraudulent financial reporting. The presence of CEO duality and board stock options decrease the likelihood of fraudulent financial reporting. If no CEO duality and no board options are produced, fraudulent financial reporting becomes less likely. If there are board options, that likelihood increases. When a firm’s board of directors has stock options, the likelihood of fraudulent reporting decreases. The higher the CEO options, the less likely the firm is to report financial fraud.
Dr. Elijah Clark (June 23, 2015). Loan Evaluation [Web log post]. Retrieved from http://elijahclark.com/loan-evaluation/