Last week, I shared posts by Daniel Lemma where he discussed financial ratios. Today, I will talk about the most common financial ratios to small businesses, their usefulness, and their interpretations. This topic is important because a lot of benefits are associated with small businesses calculating their financial ratios. These include:
The numbers in the accounting books tell a story. They show where a business has been and suggest where it's headed. Using ratios to compare financial numbers helps a business recognize successes and solve problems. The key financial ratios for small businesses operate as a kind of shorthand that captures significant metrics to create a snapshot of how particular aspects of the business are operating. These financial ratios compare a business's present conditions to past performance and help to identify the gains and weaknesses of a business. By looking at trends in strengths and shortcomings, a business can improve business operations.
Some of the most important financial ratios for small businesses are as follows:
A. Profitability ratios
This is a performance ratio. They are a class of financial metrics that are used to assess a business's ability to generate earnings relative to its revenue, operating costs, balance sheet assets, or shareholders' equity over time, using data from a specific point in time. Profitability ratios indicate how efficiently a company generates profit and value for shareholders. The profitability ratios that are of importance to small businesses are gross ratio, net ratio, and return on assets. These ratios are important because they helpCompare your business to other companies, reveal problems with your business, provide useful information to potential investors, and act as a good benchmark for seasonal businesses. They also help to determine the performance of your business
Here, I will use the most common metrics measurement, so, what applies to your business depends on the industry in which your business exists
1. The gross ratio
This is aratio that compares the gross margin of a company to its revenue. A gross ratioof 50% to 70% is considered good. If it is at this level, It means that the businessis successfully producing profit over and above its costs.
2. The net profit
This ratio measures the company's profits to the total amount of money brought into the business. This is considered good at 20%. If it is at 20%, It means a company can effectively control its costs and/or provide goods or services at a price significantly higher than its costs.
3. Return on assets
This is a profitability ratio that provides how much profit a company can generate from its assets. Return on asset of over 5% is considered good and at 20% is considered excellent. A higher ROA means a company is more efficient and productive at managing its balance sheet to generate profits while a lower ROA indicates there is room for improvement.
B. Efficiency ratios
This is also known as activity ratios. Efficiency ratios are metrics that are used in analyzing a company’s ability to effectively employ its resources, such as capital and assets, to produce income. These ratios measure how well a company is managing its assets. The ratios are indicative of the company's ability to turn its assets into income in the short term.
We will talk about two common efficiency ratios for small businesses. They are the inventory turnover ratio and the asset turnover ratio
1. Inventory turnover
This is a measure of the number of times inventory is sold or used in a period such as a year. It is calculated to see if a business has an excessive inventory compared to its sales level. A higher ratio tends to point to strong sales and a lower one too weak sales. When the inventory turnover ratio is high, it depicts that the company has been managing its inventory quite well, with lesser holding costs and fewer chances of obsolescence. Hence, a high figure will mean a good inventory turnover ratio. On the other hand, when the inventory turnover ratio is low, it signifies that a company’s inventory turnover is very low, and its products are often not sold in the market. As a result, the company’s inventory becomes a slow-moving inventory, which leads to higher inventory costs and fewer profits. It is between 5 and 10 for most industries
2. Asset turnover ratio
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The asset turnover ratio measures the efficiency of a company's assets in generating revenue or sales.it is an indicator of the efficiency with which a company is using its assets to generate revenue. A higher ratio is generally favorable, as it indicates an efficient use of assets. A lower ratio indicates poor efficiency, which may be due to poor utilization of fixed assets, poor collection methods, or poor inventory management. If the ratio is less than 1, then it’s not good for the company as the total assets cannot produce enough revenue at the end of the year. If the ratio is greater than 1, it’s always good. Because that means the company can generate enough revenue for itself. This all depends on the industry in which the business exists.
C. Liquidity ratios
A liquidity ratio is a type of financial ratio used to determine a company's ability to pay its short-term debt obligations. The metric helps determine if a company can use its current, or liquid, assets to cover its current liabilities. It helps understand the availability of cash in a company which determines the short-term financial position of the company. A higher number is indicative of a sound financial position, while lower numbers show signs of financial distress. The most important liquidity ratios to small businesses are the current ratio and quick ratio.
a. Current ratio
The current ratio is a liquidity ratio that measures whether a firm has enough resources to meet its short-term obligations. The current ratio isa metric used by professionals to understand a company's financial health at any given moment. It is aliquidity measure that assesses a company's ability to sell what it owns to pay off debt. The current ratiois an indication of a firm's liquidity. Acceptable current ratios vary from industry to industry. In general, a current ratio of2 or higheris considered good, and anything lower than 2 is a cause for concern. Since it describes the relationship between a company's assets and liabilities. So, a higher ratio means the company has more assets than liabilities. For example, a current ratio of 4 means the company could technically pay off its current liabilities four times over.
b. Quick ratio
It is also known as the acid-test ratio. It is a short-term liquidity metric, which measures the ability of a company to use its near cash or quick assets to extinguish or retire its current liabilities. The quick ratio isa formula and financial metric determining how well a company can pay off its current debts. It isused to evaluate whether a business has enough liquid assets to be converted into cash to pay its bills. Creditors and investors use the quick ratio to determine whether a company is a suitable option for funding or investment. A result of 1 is considered to be the normal quick ratio. It indicates that the company is fully equipped with exactly enough assets to be instantly liquidated to pay off its current liabilities.
4. Solvency ratio
This is also known as the leverage ratio. It measures a company's ability to meet its long-term debt obligations. A solvency ratio is a key metric used to measure an enterprise's ability to meet its long-term debt obligations and is used often by prospective business lenders. A solvency ratio indicates whether a company's cash flow is sufficient to meet its long-term liabilities and thus is a measure of its financial health.A stronger or higher ratio indicates financial strength. In stark contrast, a lower ratio, or one on the weak side, could indicate financial struggles in the future. Every company and industry has its characteristics that influence the financial outlook.
The most common solvency ratio for small businesses is the debt-to-equity ratio, the debt-to-assets ratio, and the interest coverage ratio.
The debt-to-equity ratio shows how much of a company is owned by creditors (people it has borrowed money from) compared with how much shareholder equity is held by the company. It isa leverage ratio that calculates the value of total debt and financial liabilities against the total shareholder's equity. It is used to evaluate a company's financial leverage. The optimal debt-to-equity ratio will tend to vary widely by industry, but the consensus is that it should not be above a level of 2.0. While some large companies in fixed asset-heavy industries (such as mining or manufacturing) may have ratios higher than 2, these are the exception rather than the rule. A high debt-to-equity ratio indicates that a company is borrowing more capital from the market to fund its operations, while a low debt-to-equity ratio means that the company is utilizing its assets and borrowing less money from the market.
2. Debt-to-assets ratio
The debt-to-total-assets ratio shows how much of a business is owned by creditors (people it has borrowed money from) compared with how much of the company's assets are owned by shareholders. it is primarily used to measure a company's ability to raise cash from new debt. Ithelps to understand the degree to which a company's operations are funded by debt.That evaluation is made by comparing the ratio to other companies in the same industry. The higher a company's debt-to-total assets ratio, the more it is said to be leveraged. Generally speaking, a debt-to-assets ratiobelow 1.0would be seen as relatively safe, whereas ratios of 2.0 or higher would be considered risky. This all depends on the industry in which the business exists. A debt-to-asset ratio that's greater than one can also show that the business funds most of its debt with its assets. Higher ratios usually show that a business may be at risk of defaulting on loans, especially if the interest rate increases.
3. Interest coverage ratio
It isa financial ratio that is used to determine how well a company can pay the interest on its outstanding debts. Itmeasures a company's ability to meet required interest expense payments related to its outstanding debt obligations on time. It allows investors, financial institutions, and the market to understand the current ability of the firm to pay accumulated debts. it represents how many times the company can pay its obligations using its earnings. The lower the ratio, the more the company is burdened by debt expenses and the less capital it has to use in other ways. An interest coverage ratio of 1.5 is considered as healthy for a business. In general, a higher interest coverage ratio means that a company is earning sufficient money to pay off the interest due on long-term loans, which indicates that there is very less chance of a financial default.
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