Having a firm understanding of how your SME is performing on various fronts is crucial in ensuring that the business is operating more or less on par with the plans laid out in the budget and business plan. Frequently calculating key financial ratios that snoop into and reveal underlying business performance is one of the best ways of doing this. In a recent article we explored some Key Business Health Metrics, discussing how ratios like the net cash flow, acid test, debt ratio and interest cover can help uncover any ticking time bombs that could cause potentially serious problems for any business. In this article we’ll push the boundaries a little further, and talk about the five key categories of business ratios…
- Liquidity Ratios. These exist to report the underlying ease with which your SME is able to meet its short term bills and liabilities. Many SME owners who aren’t especially well versed in finance often fail to make the distinction between liquidity and profitability. A company might well enjoy underlying profitability, but if actual cash-flows from all those sales are only payable a long time from now (or worse still, a key customer defaults on a huge sale that’s already been provided) – wheres the money coming from for your workers salaries, the rent, the electricity and all other bills? Proper use of liquidity ratios will help you to keep your working capital at optimum levels.
- Leverage Ratios. Companies that are experiencing surging demand, and desperately need funds to grow their operations to cater for it certainly make a great case for applying clever, strategic leveraging tactics. However, a company that’s geared up to its eyebrows could be trading with substantial risk – Factors such as a sudden slowdown in business, or gradual rate increases could quickly drag a company into the red. Leverage ratios exist to compare the debt to equity levels of your SME, and it’s ability to service debt interest.
- Operating Financial Ratios. This type of ratio unveils the underlying performance of the company and its staff. Operating ratios look to measure how efficiently your staff are employing the company’s capital. Many operating based ratios will measure how efficiently inventories, stocks and other processes are being utilized. One of the most common examples of an operating financial ratio includes the inventory turnover.
- Profit Ratios. This type of ratio reveals the stories behind the companies profits, and how good a return capital employed within the business is achieving. When investigating profit ratios further, you’ll inevitably come over specific ratios such as return on capital employed, gross and net profit margins and a great many others.
- Solvency ratios. These are calculations that look to measure how comfortably the company will continue to trade as a going concern in the future.
In ending it’s always important to remember that any financial ratio by itself is essentially useless. A ratio is only valuable when compared to other similar ratios – this can be against ratios predicted within the business plan or budget, or against industry averages and other similar companies.