This week we discuss how to know how healthy a company is and what makes a company less risky to invest in.
To understand today’s idea, we will first need to understand what assets and liabilities mean in accounting.
Assets are anything valuable the company owns. Like cash, receivables, and inventory.
Liabilities are the loans the company has and owes to others. Like credit card balances, lines of credit, and loans to repay.
Now that we understand assets and liabilities lets look at what makes a company less risky to invest in.
The less debt there is compared to assets the better. There is a specific term the financial world calls this. its debt to asset ratio.
Debt to asset ratio means, what percent of your assets are liabilities.
The lower the number is the better. (Read about 7 more signs of a healthy business)
This shows that even if you borrow money, you are generating more money than what you borrowed.
In one sentence, it says that you are making money, not just moving money around. (Read how to increase your profits on amazon)
It is one of the key numbers investors look at.
Let’s make it a little simpler:
Imagine you borrow money to grow your company and hope that the profits you make will be enough to repay the loans. What happens often is that you will need more money to buy more inventory, and you won’t have enough money left to pay back the loan. At one point your company will need to be in a place where it makes enough money so you can spend more and grow.
But many owners don’t keep their eye on this and can go on for years without really making money.
You can be different and yes keep your eye on this number and see that it goes in the right direction.
Here is what you can do:
First, calculate your debt-to-asset ratio by adding together all your assets as of today. Let’s say you have 100k in your bank accounts and you have 300k in inventory, your total assets are 400k. Now add together all your liabilities. Let’s say you have 50k in CC balances and 200k in a line of credit, your total liabilities are 250k. Now divide your total liabilities by your total assets. Which is 0.625. Meaning 62% of your assets are loans.
To know what’s your ratio is you need to sum up all your assets as of today. Then sum together all your liabilities. Take the total liabilities and divide it by your total assets. This is your Ratio.
Anything lower than 0.6 (60%) is a healthy sign.
Now that you know what to look out for, make sure you keep track of this and if you see that it’s higher than you want, start digging in and find the reason it’s so high.
Hope this helps you build a healthier business.
