DIRECTIONS: Read the passage carefully and answer the questions that follows.

Financial ratio analysis is especially useful for small businesses. Readily available sources of key financial ratios provide comparative data by size, with the class size varying down to some very small firms. For example, Robert Morris Associates provides comparative ratios for a number of small - firm classes, including the size range of zero to $250,000 in annual sales. Nevertheless, the financial analysis of small firms presents some unique problems that are related to risks and to depth and quality of management. We examine here some of those problems from the standpoint of a bank loan officer, one of the most frequent users of ratio analysis.

When examining a small - business credit prospect, a banker is essentially making a prediction about the ability of the company to repay its debt if the bank extends credit. In making this prediction, the banker will especially be concerned about indicators of liquidity and about continuing prospects for profitability. The banker will elect to do business with a new customer if it appears that loans will be paid off on a timely basis and that the company will remain in business and therefore be a customer of the bank for years to come. Thus, both short-run and long - run viability are of interest to the banker. On the other hand, the banker’s perceptions about the business are important to the owner-manager, because the bank may become a vital source of funds as the firm’s needs increase in the future.

The first problem the banker is likely to encounter is that, unlike the bank’s bigger customers, the small firm may not have audited financial statements. Furthermore, the statements that are available may have been produced on an irregular basis (for example, in some months or quarters but not in others). If the firm is young, it may have historical financial statements for only one year, or perhaps it has none at all. Also, the banker will probably require that periodic financial statements be produced by a reputable accounting firm, not by the owner’s brother-in-law.

The quality of its financial data may therefore be a problem for a small business that is attempting to establish a banking  relationship. This may keep the firm from getting credit even though it is really on solid financial ground. Therefore, it is in the owner’s interest to make sure that the firm’s financial data are credible, even if it is more expensive to do so. Furthermore, if the banker is uncomfortable with the data, the firm’s management should also be uncomfortable: Because many managerial decisions depend on the number in the firm’s accounting statements, those numbers should be as accurate as possible.

For a given set of financial ratios, a small firm may be riskier than a larger one. Often small firms produce a single product or else rely heavily on a single customer, or both. For example, several years ago a company called Yard Man, Inc., manufactured and sold lawn equipment. Most of Yard Man’s sales were to Sears, so most of Yard Man’s revenues and profits were due to the Sears account. When Sears decided to drop Yard Man as a supplier, the company was left without its most important customer. Yard Man is no longer in business. Because large firms typically have a broad customer base, they are not as susceptible to a loss of such a large portion of their business.

A similar danger applies to a single - product company. Just as the loss of a key customer can be disastrous for a small business, so can a shift in the tides of consumer interest in a particular fad. For example, Coleco manufactured and sold the extremely popular Cabbage patch dolls. The phenomenal popularity of the dolls was a great boom for Coleco, but the public is fickle. One can never predict when such a fad will die out, leaving the company with a great deal of capacity to make a product that no one will buy and with a large amount of overvalued inventory. Exactly this situation hit Coleco, and it was forced into bankruptcy in 1988.

The extension of credit to a small company, and especially a small owner-managed company, often involves yet another risk that is less of a problem for larger firms - namely, dependence on the leadership of a single key individual whose unexpected death could cause the company to fail. Similarly, if the company is family owned and managed, there is typically one key decision maker, although perhaps several other family members are involved in helping to manage the company. In the case of the family business, the loss of the top person may not wipe out the company, but it may create the equally serious problem of who will assume the leadership role. The loss of a key family member is often a highly emotional event, and it is not at all unusual for it to be followed by an ugly and prolonged struggle for control of the business. It is in the family’s interest, and certainly in the creditors’ interests, to see that a plan of management succession is clearly specified before trouble arises. If no good plan can be worked out, perhaps the firm should be forced to carry “key person insurance,” payable to the bank and used to retire the loan in the event of the key person’s death.

In summary, to determine the credit-worthiness of a small firm, the financial analyst must look beyond the basic financial ratios and analyze the viability of the firm’s products, customers, management, and market. It is not an easy task, but it must be done. Ratio analysis is only the starting point.

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