Investigating your SME’s financial ratios is a great method for understanding performance. It helps to compare how you’re doing within a particular industry, and shows whether you’ve racked up any debts as well as a whole host of other performance predictions that could help you in the long run.
Here, we’ll guide you through some of the financial ratios you should be monitoring on a monthly basis, explaining how to work them out, what they entail and their importance to measuring your business’ overall health.
Financial ratios provide SMEs with ways to evaluate their company’s financial performance, and then compare it to other businesses in their industry.
These ratios work by comparing two or more components of a business’ financial statements. Most effective when comparing results over several periods, they determine your company’s performance over time, and clue you in to any signs of trouble along the way.
Ratios provide essential quantitative analyses, identifying positive and negative financial trends which allows businesses to create and implement financial plans and, if necessary, course-correct in the short term.
There are certain types of ratio used to determine particular pieces of financial information. Common-size ratios are important for making comparisons of assets and liabilities; these can be used to identify certain trends, such as decreasing cash and increasing accounts receivable balances.
Operating expense and turnover ratios, meanwhile, can be used to assess how efficiently your business is utilising assets and managing liabilities. These ratios compare things such as rent, inventory purchase and ad-to-sales revenue. Low ratios in these areas can show you’re managing expenses successfully, while high ratios signal that there will need to be a degree of improvement here.
Ratios associated with cash and liquidity can help to show whether you can afford to invest in capital assets or long-term business growth. Current ratios, for instance, are good for assessing whether your business has enough liquidity to pay for daily operating and short-term debt expenses. If your business is sufficiently liquid, then here’s where you can begin incorporating capital or market investments into your business’ financial plan.
A surge in demand requires the necessary funding to meet that demand. If a company lacks funds, then they’ll take out a loan, with the expectation that the future sales will cover the cost of borrowing. However excessive use of debt, or leveraging, can cause problems, since the large chunk of money for the loan leaves little for marketing, research and development.
Leverage ratios are there to compare the debt to equity levels of your SME in order to finance operations, and can help give an idea of how these changes in output will affect the income as a result, something that’s well worth investigating before you borrow. A lower ratio is considered to be a good indicator that you can repay your debts, in addition to taking on additional debt to support other endeavours.
In order to calculate this ratio, you first have to calculate the total debt owed by your SME, including long and short-term debt, as well as mortgages and money due for service provided. Following this, estimate the total equity the shareholders hold in your company.
Divide the total debt by the total equity. This final number represents your leverage ratio.
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At its core, the liquidity ratio assesses a business’ ability to pay its bills when they are due, indicating the ease of turning assets into cash. It’s an important ratio to become well versed in, since many SME owners who are unfamiliar with finances tend to confuse liquidity and profitability.
You may well be profitable, but you need to have the money to cover salaries, rent, electricity and other bills. The liquidity ratio can help with this; the higher the ratio (i.e. more current assets than current liabilities), the greater your ability to face up to periods where the cash flow is tight.
To work out your current liquidity ratio, divide your total current assets by your total current liabilities. Depending on the nature of your business, your current assets may be made up mainly by cash, therefore it’s possible to survive with a relatively low ratio.
Speaking of which, the solvency ratio indicates your business’ level of available cash to meet current debt obligations. In times of reduced cash flow, will you be able to pay off debts, interest expense obligations and liabilities from other sources?
As a long term-assessor of a business’ health, solvency ratios are invaluable to a company as they also help to investigate trends that could lead to bankruptcy. Compare your solvency ratio to the industry average by looking to those companies prospering in your sector; if there’s only a small deviation this could be indicative of good business health. However, limited solvency could be a sign you’re unlikely to weather stormy economic conditions.
Broadly speaking, calculating your solvency ratio involves adding together your total After Tax Net Profit with non-cash expenses, and dividing them by your total liabilities.
As a general rule, a solvency ratio higher than 20% is considered financially sound.
Put simply, the profitability ratio of your business measures how successful you are. It lets you measure your financial viability, stacks you up against others in your industry and can look for trends by comparing your company’s annual ratios.
In measuring the profitability of your SME, we can look to the net profit margin, a measure of how much a company earns after taxes relative to its sales – companies with a high profit margin are more efficient, flexible and able to take on new opportunities when compared to competitors.
Elsewhere, the return on equity analyses how well the business is doing in relation to the shareholders’ investments. Incredibly important to investors, your return on equity is what potential investors look to in their decision to invest in the company or not. As a rule of thumb, the higher the percentage, the better: it shows your company is putting investors’ money to good use.
To work out your business’ net profit margin, divide net profit by total revenue – providing one of the most commonly used profitability ratios.
Used to investigate how well a company uses its assets and liabilities internally, efficiency ratios help to calculate the turnover of receivables, the repayment of liabilities, the quantity and usage of equity, and use of machinery.
Additionally, these ratios measure how a company can use its assets to generate income, so an improvement in an SME’s efficiency ratios generally means an improved profitability.
The most common way to work out your SME’s efficiency ratio requires dividing your expenses (not including the interest expense) by your revenue.
Also known as the acid test, the quick ratio is used to evaluate your company’s ability to meet short-term financial obligations. They only measure short-term liquidity, so don’t include inventory, but can be used to determine how many pounds you have in assets compared to pounds in liability.
You should have a quick ratio of 1.0 or more to be able to meet your financial obligations. If not, you won’t be able to pay all your liabilities.
To work out your business’ quick ratio, take away the total value of your inventory from your current assets, then divide this number by your current liabilities.
Similar to the above, the current ratio also measures your ability to pay long-term debts. Thus, it looks at how many assets, including inventory, the business has compared to its liabilities. This is used to calculate whether you can meet both immediate and future financial obligations.
If you’re looking to meet your financial obligations and current ratio, then divide your current assets by your current liabilities.
As its name suggests, the ROI ratio shows how much your company has gained from the investment you’ve made. The resulting figure is a percentage that will help you determine which investments were successful and which weren’t; thus, the higher the figure, the more income you make per investment.
Take away the cost of your investment from the gains made from your investment. Once you have this figure, subtract the cost of investment from it to determine your return on investment.
This ratio shows how dependent you are on borrowed finances compared to your own funding by comparing how much you owe to how much you own.
You’ll need to know your business net worth and total liabilities to calculate this ratio. Take away the former from the latter and you’ll find out your debt-to-worth.
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