As a small business owner, you have to make financial decisions frequently. Your choices can have far-reaching consequences if taken in blind. For instance, your business could be cash-strapped if you paid your supplier in cash without checking your cash availability against the upcoming payments. Most surveys noted a lack of cash as the primary reason most startups fail.
A business owner should always make decisions looking at the current financial health of their business. But remembering numbers like $280,524 or $35,433 are taxing and does not make business sense. That is why you need financial ratios.
What Are Financial Ratios?
Financial ratios are representations of financial data in your books of accounts in ratios or percentages. They give more insights as they tell you the correlation between two financial figures and help you compare them with your historical data, with competitors and industry averages.
Some financial ratios are common for all businesses, and some are sector and business-specific. This article will look at the four most common ratios that apply to every business and how they help in decision-making.
What Working Capital Ratio Means For Small Business Owners
Working capital means how much money you need to meet your current liabilities, like a line of credit, accounts payables, and the current portion of your long-term debt. The ratio sees if you have sufficient existing assets like cash, inventory and receivables to meet the current liabilities.
Working capital ratio = current assets / current liabilities
A ratio of 1.0 and above shows your business has sufficient current assets to meet the current liabilities. If this ratio is constantly high, you have the flexibility and liquidity to invest in expansion, new product launches, faster debt repayment, or any other business plans you have on your list. But ensure the ratio is not high because of high inventory that is becoming obsolete.
If the working capital ratio is below 1.0, it calls for action, such as following up with clients to collect receivables, delaying supplier purchases, or taking short-term credit. If a lower working capital persists for a longer time, there is some discrepancy, like your cash reserve is too low or your monthly debt payment is too high. If monthly debt payments are too high, you might consider restructuring your debt with lower monthly payouts.
Cash Conversion Cycle
Just having sufficient working capital is not enough. You need timely capital to ensure receivables or inventory funds the payables. A cash conversion cycle tells you how many days it takes to convert cash into inventory and then convert inventory back into cash in a period (monthly, quarterly, half-yearly).
Cash conversion cycle = Average days inventory + Average days receivable – Average days payable
Average days inventory = Average inventory x days in a period/cost of goods sold
You can determine the period depending on your business cycle. For instance, a restaurant might have a low inventory period (a day or a week), whereas a garment manufacturer might have a higher inventory period. The average days of inventory tell you how frequently you need to order in a period (month, quarter) or if you should place a more significant order.
Higher inventory days can act as an alarm that inventory could become obsolete. You can do away with the inventory by selling it in a discount sale or giving it away as free gifts with every order. It will help you recover inventory costs and avoid taking a loss.
Similarly, you can calculate
Average days of receivables = average receivables x days in a period/revenue
Average days of payable = average receivables x days in a period/ cost of goods sold
If you are in a service business, like running a dental clinic, and give your customers 20-22 days to pay the invoice, ensure your payables are higher than receivables. If the average receivables days increase, you might want to revisit the procedure to follow up and collect payments. You can offer customers discounts for immediate payment or accept payment through various mediums (digital, card, and cash).
When Do Small Business Owners Use Debt to Equity Ratio?
Now let’s look at the other aspect of the working capital, debt. Having too much leverage reduces the financial flexibility of businesses. In a prolonged challenging environment, a high-debt company might default or refinance its debt with a longer tenure. Banks and investors look at the debt-to-equity ratio to decide whether or not to lend more money.
A debt-to-equity ratio of less than 1.0 indicates you have more equity and lesser debt obligations. But if your debt to equity is above 1.0, banks look at your debt coverage ratio to gauge your ability to pay interest and principal.
Debt coverage ratio = EBITDA/ interest + payments
Before seeking a loan, improve your debt coverage ratio and net profit margin.
Net Profit Margin
This ratio is the reason you came into business. Some businesses have high net profit margins some have low. You can compare your margin with the industry margin to understand if your business is doing well. If your margin is lower than the industry margin, it shows there is scope to cut costs. You can then look deeper into the books and identify areas of improvement.
The biggest challenge with these financial ratios is they might paint a false picture if not updated. A professional bookkeeper can keep your books updated and prompt you if any relevant ratio call for immediate action.
Contact Edelkoort Smethurst CPAs LLP in Burlington For Bookkeeping Services
A skilled bookkeeper can help you make informed decisions knowing the financial capacity of your business. At Edelkoort Smethurst CPAs LLP, our experts can provide services to support bookkeeping and financial analysis, whether you need partial or complete support. To learn more about how Edelkoort Smethurst CPAs LLP can provide you with bookkeeping expertise, contact us online or by telephone at 905-517-2297