Profitability doesn’t always equal stability. Your business’s ability to withstand a temporary issue is the real test to its viability. For example, if you’re able to bounce back after a decrease in sales or loss of a key customer, then your finances will prove to be stable. However, you can’t just wait around for something like this to happen – there are ways to test your business’s stability so that you can prepare for any problems that may occur.
Working out your financial ratios is one way to analyse your business’s financial health. These are used to make comparisons between different aspects of a company’s performance, revealing information such as whether you have accumulated too much debt or have bought too much stock in bulk.
A common use of financial ratios is when a business wishes to take out a loan – the lender can use ratios to assess whether or not to grant the loan. Looking at your business’s balance sheet, they can determine its stability. This document provides an overview of your company’s assets as well as its liabilities. Looking at your financial ratios, they will take them into account as part of the loan agreement. To give an example, your business may have to keep its equity above a certain percentage of your debt for them to consider granting you the loan.
There are different types of ratios that, ideally, you should review each month to keep on top of your finances. Simple to calculate, financial ratios are easy to use and provide owners with insights into what is really happening within their business, insights that, on the surface, are not always identifiable in financial statements alone.
It’s important to note that taking financial ratios are time sensitive and can be impacted by external factors – such as increased sales around Christmas time, for example. There are four main categories of ratio, each with several specific calculations prescribed within each.
As stated above, just because a business is making money, it doesn’t mean that it is stable. That’s why business owners use profitability ratios to assess management’s performance in using all their resources. If these ratios don’t prove that the business is making a good return on investment, then creditors or investors may wish to reinvest their money elsewhere. Some ratios to work out the stability of profits within a business are:
- Gross profitability– Gross profits divided by net sales
- Return on investment (ROI) – Net income divided by the cost of investment
- Investment turnover – Net sales divided by total assets
- Return on equity (ROE) – Net income divided by shareholders equity
Liquidity ratios measure the amount of liquidity that the business has to cover its debts. Basically, they assess whether the company is able to pay short-term debts and any other liabilities.
- Current ratio - Current assets divided by current liabilities. This ratio will give you an idea of your business’s ability to generate the money needed to meet your short-term financial commitments.
- Quick ratio - “quick” assets divided by current liabilities. Quick assets include cash, marketable securities, and receivables, but not inventory. This provides a stricter definition of your business’s ability to make payments on current obligations. A ratio of 1.0 or higher is generally acceptable. However, this will vary depending on your industry and other outside factors such as time of year. If it’s less than 1.0, it may indicate that the business relies too heavily on inventory.
Leverage ratios work out a business’s dependence on loans to finance itself. Investors and creditors take particular notice of this when assessing the business. They provide an indication of the long-term solvency of the business.
- Debt to equity ratio – debt divided by owners’ equity. This is to assess how your assets are financed - by your own investment, or by creditors. A low ratio is generally considered better for them as it indicates your ability to repay your debts.
- Debt ratio – debt divided by total assets. if this is greater than 1.0, it means the company has a negative net worth.
Efficiency ratios give business owners an insight into different aspects of their business, helping them to do better business overall. Working out your efficiency ratios can help you assess whether your business’s credit terms are appropriate as well as whether your purchasing efforts are efficient enough to make the business viable.
- Inventory turnover – This looks at how long it takes for your inventory to be sold and replaced. It’s worked out by dividing the cost of goods sold by average inventory. This will give you a good idea of how well the company is managing its production and productivity. Generally speaking, the higher the ratio, the better.
- Inventory to assets ratio – inventory divided by total assets. This will give you an idea of the number of assets tied up in inventory.
- Collection period – receivables divided by total sales, multiplied by 356. This looks at the average number of days customers take to pay for your products/services. To improve this ratio, you could establish clearer credit policies.
What makes a business viable?
Overall, a viable business is assessed through its financial stability, not just in the short-term, but in the long-term too. If a business is able to recover from issues such as loss of a key employee, a lull in sales, or external factors such as time of year, then it’s generally considered as viable.
The financial ratios highlighted in this blog post will help you to review your business’s health and make improvements where possible.
At McAlister & Co, our team of licenced Insolvency Practitioners help businesses to navigate through financial hardship and insolvency. If you have any concerns about the health and viability of your business, don’t hesitate to contact us.