Are you familiar with the use of financial ratios for small and medium-sized businesses?
Financial ratios are calculated to measure the financial status of your business. They provide an in-depth look at your company's financial health with the goal of obtaining more financing. This will also enable you to adjust your operations based on the results obtained, improve your performance and keep an eye on your competitors. The ultimate aim is to save you considerable time and money as a business manager.
In this article, discover 3 types of financial ratios that help SMEs better understand their performance.
1. Liquidity ratios for better compliance with your financial commitments
Liquidity ratios are used to measure your SME's ability to repay its debts and meet its financial commitments. These ratios are especially interesting for creditors, since they can quickly see your company's financial situation and take its pulse before investing.
Current ratio
The first ratio in this category is the current ratio, or working capital ratio. This ratio measures the company's ability to meet its short-term commitments.
To calculate it, simply divide your current assets (inventory, cash and accounts receivable) by your current liabilities (line of credit balance, long-term debt or accounts payable). The higher your SMB's current ratio, the more solvent your business is. It is therefore a good indicator of short-term performance.
Quick ratio
The quick ratio measures your company's ability to quickly access cash to meet immediate commitments. It is also often referred to as the cash flow ratio, because it indicates the company's financial readiness to meet a short-term deadline.
This ratio is calculated by dividing current assets (excluding inventory) by current liabilities. Depending on your industry, a ratio greater than or equal to 1.0 is considered acceptable. On the other hand, a ratio of less than 1.0 may indicate that your company is in financial trouble, as it is not able to access cash quickly.
2. Profitability ratios to measure the financial viability of your business
Profitability ratios are some of the most important financial ratios. They are used to assess the development and viability of your SME based on your financial statements. Above all, however, using these ratios will allow you to compare your financial performance with that of other companies in your field of activity.
Here are three examples of profitability ratios.
Net profit margin ratio
This ratio measures how much your company earns in relation to your sales. It is called the net profit margin because this financial ratio is calculated after taxes. This percentage is obtained by dividing your net profits by your net sales. If your ratio is higher than that of your competitors, it could mean that your company is financially healthier and capable of positioning itself for new opportunities.
Return on total assets ratio
The return on total assets ratio is a percentage that measures the profitability of the total assets and capital invested in your business. Simply divide your net income by the value of total assets to obtain it. The result indicates whether the company's resources and assets are being properly utilized by management.
Not surprisingly, the higher this ratio, the more profitable and efficient your use of total assets. However, a caveat is that this number may be subject to industry-specific realities, such as a tendency for high asset utilization if you are a service company.
Coverage ratio
Also known as operating profit margin, this profitability ratio provides a tendency to leverage or rather to secure further investments. The coverage ratio measures earnings before interest and taxes and can be very different from the net profit margin.
3. Leverage ratios to evaluate your long-term financial performance
Leverage ratios are financial ratios that show the long-term financial health of your company and its use of long-term borrowing. They are different from liquidity ratios.
There are several types of leverage ratios. Here are some examples.
Debt ratio
As its name suggests, the debt ratio allows you to see how your assets are financed (by creditors, by you, etc.). This ratio is mainly used by banks (as it is for individuals) to measure your ability to repay your debts.
The ratio is calculated by dividing your total liabilities by your total assets. A low ratio is usually a good sign for banks. It indicates that your assets are greater than your liabilities.
Leverage ratio
The leverage ratio relates the amount of total assets financed by the company to each dollar invested by shareholders. It is calculated by dividing total assets by equity.
Also known as return on equity, it is used to measure the profitability of your company in relation to the investment of your creditors.
Need more advice on accounting and business taxation?
In short, calculating the liquidity, profitability and leverage ratios allows you to have a better overview of the financial performance of your small or medium-sized business. This will make it easier for you to set goals for the growth and development of your company.
Do you need more advice on financial management, taxation and business accounting? At T2inc, our qualified tax accountants can help you set up a strategic plan for your SME.
Contact us today to learn more about our tax and accounting services designed for businesses! In addition, our online corporate tax solution allows you to file your T2 and Co17 reports with confidence and the assistance of real professionals.
Frédéric Roy-Gobeil
CPA, M. TAX
As President of T2inc.ca and an entrepreneur at heart, I have founded many start-ups such as delve Labs and T2inc.ca. A former tax specialist at Ernst & Young, I am also a member of the Ordre des comptables professionnels agréés CPA and have a master's degree in taxation from the Université de Sherbrooke. With a passion for the world of entrepreneurship and the growth mindset, I have authored numerous articles and videos on the industry and the business world, as well as on accounting, taxation, financial statements and financial independence.
