It's been a little while since I added to my series on evaluating commercial real estate investments. If you recall, we were analyzing a small retail property in downtown Reading, PA. We looked at several aspects of the property's performance, from NOI through IRR, but one thing that we did not look at was the quality of the tenant. There are several things to consider when looking at a potential tenant, but today I am just going to cover two important ratios that you should look at when evaluating the balance sheet of a potential tenant.
The first ratio I always like to look at is the Current Ratio. This is a measure of how well a company is positioned to handle its short term cash needs. The Current Ratio is calculated by dividing the company's current assets by its current liabilities.
It is essential that this number is greater than 1, and the larger it is the better off you are. So does that mean as long as our small retail tenant that we're considering has a Current Ratio of 2 that we are safe? Not necessarily. One portion of a company's current assets can be made up of inventory. Sometimes companies that have excess inventory have strong Current Ratios, but are still unable to pay their current liabilities. For example, if a company has $2 in cash, $8 worth of inventory and owes the bank a payment of $6, they are only able to pay the bank if they are able to sell half of their inventory immediately.
For this reason, I also like to take a look at a company's Quick Ratio. To calculate your Quick Ratio, you first subtract your inventories from your current assets, and then divide the difference by your current liabilities.
Determining the financial strength of your potential tenants is one of the easiest ways to mitigate the risk of purchasing commercial real estate. If you are interested in purchasing a retail property in Reading, PA, and you'd like help evaluating your potential tenants, give me a call today.