By: Alexander Carbone
Running a successful business in Canada is becoming increasingly complex. With so many digital tools available, the options to help you manage your small business are becoming more diverse than ever before. In this article, I will introduce some tools and ratios (calculations to measure how well your company’s doing) you can use to analyze the financial performance of your small business and make informed decisions about how to improve your bottom line.
Are you using your money efficiently?
As an entrepreneur, you probably watch your profits carefully. While sales are an important indicator of performance, how well you convert sales into profit after accounting for all of your operating expenses is a very important metric. However, what you might not know is that profitability should be assessed not only in terms of year-over-year or month-over-month increases, but also in terms of capital efficiency. In simple terms, this means looking at the total amount of capital you have invested in your business, like the money you have invested or the total value of tools and suppliers you own, and determining how effective you have been in turning this investment into profit. To do this, we can use the ratios below:
Return on Assets = Are your purchases helping or hurting your profits?
Formula: Profitability/Total Assets
This formula can be used to measure how efficiently you turn your assets into profit. Your assets are anything your business owns – your tools, supplies, machinery, buildings and equipment, for example. These are commonly referred to as “tangible assets” because they are physical in nature. You could also include “intangible assets” like the value of your brand, however, for a small business it is best not to do this as these are hard to value. If you have $50,000 in assets and generate $10,000 in profit per year, that is a return on assets of 20% (10,000/50,000).
Monitoring how this ratio changes every year will help you determine if you are becoming more or less efficient in converting your assets into profit.
Bottom line: If this ratio is decreasing, you may want to determine if your assets are wearing down, your costs have increased, or you are spending too much on new tools and equipment.
Return on Capital = Are you making the right investments?
Formula: Profitability/Capital
Capital is your financial assets, though there are many ways to define “capital.” Words like equity, debt, invested capital and others come to mind. However, for the small business owner, a meaningful figure of capital would be the combination of equity and debt invested into the company. In simple terms, any money you have invested in your business is your equity. This includes the start-up cash you used to buy equipment, investments from your friends and family, and any other sources of outside cash. Debt is any money you have borrowed – such as an ACCESS small business loan. Much like return on assets, this ratio is a measure of how well you are converting your invested capital into profits. Return on capital is an important metric because it tells you how successful your business is in generating returns on all the money that is invested in the business.
Bottom line: If this decreases from one year to the next, you might look at whether or not your capital is being invested appropriately.
Liquidity and Solvency Ratios = Can you meet your financial obligations?
Liquidity is your business’s ability to access cash to pay off debts and support the day-to-day operations of your business. Solvency is the ability to meet your long-term debts. Not only are efficiency and profitability important for a business, but so are your liquidity and solvency. Without liquidity, you won’t have enough cash to pay your bills.. Without solvency, you may find yourself in trouble in the future. Some ratios can help you evaluate these important concepts in your business:
Quick Ratio = Can you pay your bills without selling inventory or getting more financing?
Formula: (Cash + Accounts Receivable) / Current Liabilities
In simple terms, cash is the money you have in the bank and on hand, and accounts receivable is the cash you expect you will receive from customers that owe you money in one year or less. Current liabilities are any debts you have due in under one year. This means if you have a 20-year loan, you should only include the payments due in the next year, as well as any other obligations like amounts due from suppliers. This ratio essentially shows whether a business can meet all of its short-term (within one year) financial obligations, given the assets it has on hand.
Bottom line: You would hope this ratio is greater than 1, indicating that your business can meet these obligations. Otherwise, you might have a liquidity issue on your hands.
Interest Coverage Ratio = How likely is your business to face financial challenges?
Formula: (Net Income + Interest Charges)/Total Interest Charges
This ratio gives you insights into how much of your business’s returns are spent paying interest. A higher ratio means a greater “margin of safety” (or in other words, your business has more money left over after paying interest, and therefore is less likely to experience financial problems). Because interest charges are deducted before arriving at “Net Income”, we first add back the interest charges to find “Earnings before Interest”. For example, if you pay $200 in interest per year and have a net income of $1,000, your Earnings before Interest was $1,200. Your interest coverage ratio is $1,200/$200 = 6. This would appear to be a good margin of safety (although this would depend on your particular business). However, you might be more concerned if this was just 2, for example.
Bottom line: If your interest coverage ratio is less than 1, your interest charges are higher than the profitability of your business can reasonably support.
What Next?
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Note:
This article introduced several key financial analysis concepts for small business owners. However, there is much more to be learned. A great resource for owners is the education section of Investopedia, which introduces many of these concepts and explains them in greater detail.
(While this article discussed several financial analysis concepts, it is not financial advice, and there is no substitute for consulting with a finance, tax or accounting professional to get some personalized guidance. Happy calculating!)
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