Why are the financial ratios linked to the health of your business? The challenges of financial management in a small to medium-size company (SME) can pose a different set of problems and opportunities than those confronted by a large corporation.
One distinct difference is in the funding structure. In that, a majority of smaller companies do not usually have the opportunity to sell or issue shares publically or, to raise additional capital. , instead, the owner-manager must rely primarily on retained profits (if they exist).
Other options include trade credit, bank financing, investment financing, and personal equity to finance the business. An SME, therefore, faces a far restricted set of financing alternatives than those available to the Financial Director of a large corporation.
Here’s the rub
Many financial problems facing the small to medium companies are very similar to those of larger corporations. For example, the financial ratio analysis required for investment decisions such as the purchase of fixed assets (plant, machinery, equipment etc.).
Or securing bank loans, or even analysing the business for sale/buy is virtually the same regardless of the size of the company. The financing alternatives available may differ, but the decision-making process is generally similar once the decision made.
Business as an Investment
Performing my role as their Business Coach I look at my clients’ businesses from an investor’s point of view.
In general, the goal of the coaching process is to create a commercially profitable enterprise that works without the owner. In other words
- Put a general manager in place and receive a passive income from the business to invest in other wealth-generating activities.
- To simply to take time out of the business whenever the owner(s) wants, knowing the business will continue to grow without them.
- Sell the business, which includes family members or the management team, which inevitably means creating succession plans and/or exit strategies.
We know from previous articles that knowing your financial ratios and understanding your financial accounts is key to gaining Financial Mastery Together, with having a better relationship with your accountant.
We also know that eight of ten new businesses fail primarily because of the lack of sound financial planning.
I have previously discussed financial planning concerning the necessity for cash flow budgets, break-even analysis, marginal analysis, pricing formulas and compounding profit formulas.
And, now I want to introduce the equally critical ‘Financial Ratios Analysis’.
Financial Ratios Analysis
Who’s Responsible for the Financial Ratios Analysis?
As a business investor myself. These financial ratios are critical for my decision-making process. And, the reason I measure them for my clients.
Especially as part of an exit strategy.
However, more than ever it is now vitally important for owner-managers to take responsibility for and understand their financial business ratios because of far more weight placed on them now than in previous economies.
Particularly your bank’s financial risk analysis of your business in assessing for loans or overdrafts.
You apply financial ratios analysis to your financial statements analysing the success, failure, and trend progress of your business.
Knowing your business ratios enables the owner-manager to spot trends in their business and to compare its performance and condition with the average performance of similar companies in the same industry.
One area of particular concern for the SME business owner lies in the effective management of working capital. This number is not to be confused with cash in the bank.
Net, working capital, defined as the difference between your current assets (what you own) and your current liabilities (what you owe). This is often thought of as the “circulating capital” of the business. Lack of control in this crucial area is a primary cause of business failure. In both small and large firms.
You must continually be alert to changes in working capital accounts. Mainly, with the cause of these changes and the implications of these changes for the financial health of the company.
One convenient and effective method to highlight the vital managerial requirements in this area is to view working capital regarding its major components:
- Cash and Equivalents
- Debtors (They owe you money)
- Stock, Raw Materials & Work in Progress
- Creditors (You owe them money)
- Accrued Expenses and Taxes Payable
Key Financial Ratios to Track Include:
The Current Ratio
The Current Ratio is one of the best-known measures of financial strength. The main question this ratio answer is; does your business have enough current assets to meet the payment schedule of its current debts. Including a margin of safety for possible losses in current assets, such as inventory shrinkage or collectable accounts?
This Quick Ratio is sometimes called the “acid-test” ratio and is one of the best measures of liquidity. The Quick Ratio is a much more precise measure than the Current Ratio.
By excluding inventories, it concentrates on the liquid assets, with a value that is reasonably certain. It helps answer the question: If all sales revenues should disappear, could my business meet its current obligations with the readily convertible `quick’ funds on hand?
Gearing Ratio or Debt-to-Equity
Gearing Ratio or Debt-to-Equity is a leverage ratio that indicates the extent to which the business is reliant on debt financing (creditor money versus the owner’s equity).
Return on Investment (ROI) Ratio
Return on Investment (ROI) Ratio is perhaps the most important ratio of all. It is the percentage of return on funds invested in the business by its owners. In short, this ratio tells the owner whether or not all the effort put into the company has been worthwhile.
Stock Turnover Ratio
The Stock Turnover Ratio reveals the robustness of the inventory or stock management. It is important because the more times inventory can be turned in a given operating cycle, the higher the profit.
Debtor Days Ratio
Debtor Days Ratio indicates how long the accounts receivable take to collect. If receivables are not collected reasonably in accordance with your terms. Then, you should rethink your collection process or train your team.
Other critical financial ratios include Gross Margin, Net Margin, Creditor Day, Price to Equity and Contribution Margin.
The key is to know your financial ratios. So, you can ask the right questions with your team, your accountants, your bank relationship manager, your coach, and yourself because healthy financial ratios do equal a healthy business.