As your small business grows, so does its complexity and the need to monitor various parts of it. Inevitably, you’ll pocket more clients who will pay through varying structures and terms. Your costs will increase. Bottlenecks will rear their ugly head. You may flirt with gearing strategies to grow faster. Not all SME owners are financial geniuses – but they do need to know what parts of the business could potentially blow a fuse, and threaten the viability of the entire company.
In this article we’ll explore a few financial metrics to monitor to help give you a clue about the health of your business:
- Net Cash Flow. A collapse in your working capital can be an “Extinction Level Event” for your business. Working capital problems can appear suddenly due to shock events (eg a major contract or client defaults and you’re suddenly and unwittingly left without enough funds to pay your short term bills). Always keep a close eye on your net cash flow numbers. The metric is simple to calculate, simply extract short term cash outgoings from your cash inflows. Check to see how the metric has been trending over the past few months – is your net cash flow becoming more comfortable? Or less so? Other things to look out for, as eluded to earlier, is the composition of your cash inflow – do you have a nice, even, smattering of contracts and clients or are you reliant of a handful of major customers?
- Acid Test (Quick) Ratio. Another metric that SME owners must learn to get intimate with, the acid test ratio measures the short term liquidity of your company. It’s measured by subtracting current assets (not including inventory) by current liabilities. The acid test ratio should never be below 1 – if it is, it’s an indication that the company’s liquidity position is very poor. The higher this ratio, the more comfortable the liquidity of a company – however if the acid test ratio is too high, it points to excessive liquidity – which points to an ineffective use of the company’s short term assets.
- Debt Ratio. In a low interest economy, companies may well be tempted to leverage high levels of gearing (borrowing) to spearhead growth, or even maintain the status quo. While borrowing to grow can be a good short term tactic, over leveraging can be very risky. Particularly when high levels of gearing are taken on during a period of low interest rates – when those rates suddenly hike (and it’s worth remembering that nothing stays the same), a highly geared company might have problems servicing the debt. There are many different types of debt ratios that need to be looked at – to figure out how much of your company is powered by debt, the debt ratio can be calculated by dividing liabilities by assets. Anything beyond 0.7 might indicate that your company has too many loans on the balance sheet.
- Interest Cover. Another ratio that monitors overall debt, the interest cover ratio tells the business owner how comfortably the company is able to service interest payment on loans. The interest cover ratio is calculated by dividing net profit before interest by the interest paid.
Keeping an eye on these crucial metrics will help make sure that key parts of your business – such as liquidity and debt are not spiraling out of control.