Dear Dave
Our bank is telling us that our debt to worth ratio (4 to 1) and our current ratio (1 to 1) are not adequate. They have officially informed us that they plan to reduce our line of credit borrowing limit when it renews at the end of this year. Our line of credit is secured by all assets including our accounts receivable. We use our line of credit on a regular basis to even out our cash flow and can’t afford to have our credit limit reduced. How do our ratios compare to other firms? Are they that bad? What can we do about this?
JE MI

Dear JE
In "banker speak" your firm is too highly leveraged and ill-liquid for your current banker’s liking. But like beauty, the quality (or lack thereof) of your ratios is ultimately in the eyes of the individual beholder. Each bank has its own standards and tolerances. You may wish to shop around for another bank if you are unable to live within the limits your current bank wishes to impose or if you are not able to negotiate for what you feel your minimum needs to be.

The debt to worth ratio is the traditional grand daddy of all measures used for assessing the financial stability and risk inherent in an organization. The debt to worth ratio comes from dividing a firm’s total liabilities by its owners’ equity (net worth). A debt to worth ratio of 4 to1 means that the creditors have four dollars invested in support of the firm’s assets for every dollar of investment by the owners. The higher the ratio, the more "leveraged" a firm is said to be. The more leveraged the firm is, the more risky it becomes for lenders and other creditors to maintain or extend additional credit to the firm. A recent financial survey conducted by Wind2 Software, Ft Collins, Colorado, found the median debt to worth ratio of some 220 plus architectural and engineering firms participating in this year’s annual survey to be less than 1 to 1 (.88 to 1) which is actually quite healthy. As a former banker myself, all other things being equal, I typically did not flinch or get unduly nervous until a client’s debt to worth ratio edged up to the neighborhood of 2 to1 or higher as a general rule of thumb.

The current ratio is found by dividing current assets by current liabilities. A current asset is cash and other assets such as accounts receivable and work in progress that one would ordinarily expect to covert to cash within the coming twelve-month period. The single largest current asset usually held by professional firms is its accounts receivable. Similar in definition to a current asset, a current liability is any obligation which will be due and payable within the same twelve-month period. A current ratio of 1 to 1 indicates that for every dollar of debt coming due over the next twelve months, there should be one dollar of cash on hand to meet that obligation. The higher the current ratio, the more "liquid" or "covered" a firm is said to be. At one to one, there is no cushion or margin for error which would lead a creditor to anticipate that your firm may be likely to experience problems from time to time meeting cash payment obligations as they come due. The Wind 2 survey found the median current ratio of reporting firms to be 2.45 to 1.

To bring your firm’s ratios more in line with industry averages, and to allow your banker to feel better about your relationship, you need to work toward accumulating some additional capital within your firm. There are basically two ways to accomplish this. The first approach is to ease up on the amount of the firm’s discretionary profits you distribute each year and holdback a larger portion of your profits within the firm as retained earnings. Retained earnings add directly to owner’s equity thereby reducing the firm’s reliance on credit lines and other loans to support firm operations. The second basic way to build capital and reduce debt dependence is for the firm to sell additional stock (or ownership) positions to willing investors.

Capital is the lifeblood of organizations. Keeping your ratios healthy and your cash flow strong is fundamental Business 101. Without adequate capital, your firm will not only have difficulty meeting your day-to-day operating needs, you won’t have the resources to invest in the technology and tools needed to keep your firm current and competitive.

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