Everything you need to know about measuring the financial health of your business.
So far we’ve touched on topics to help examine the financial health of a business over the near term by looking at cash flow, liquidity and working capital. These are essential components to keep day-to-day operations running, but what about the long term? This is where solvency, profitability and efficiency measurements can be used. Together with the topics looked at earlier, a business owner will have a fuller view of the financial health of their business. These metrics can also provide insight into how investors and lenders will look at your business when you are looking for funding.
What is Solvency, Profitability, and Efficiency?
Solvency refers to a business’ ability to meet its long term financial commitments. This is different to liquidity, which relates to the ability of a business to meet payments over the short term. When thinking about a business’ solvency, we look at all of its assets and liabilities, both short term and long term, to determine its long term sustainability. Some ways to measure solvency include:
Debt to Assets Ratio
Also known as the Leverage Ratio, this is the amount of a business’ debt divided by its assets. This indicates the proportion of assets being funded by debt, and the lower the ratio, the less risky a business' financial structure is.
Debt to Assets Ratio = Debt / Assets
Debt Service Coverage Ratio
Also known as the Interest Coverage Ratio, this is a business’ earnings before interest and tax (EBIT) divided by its interest expense. This shows how many times the business can pay its interest payments with available earnings, and a higher ratio shows the business can comfortably service its debt.
Debt Service Coverage Ratio = Earnings before Interest and Tax / Interest Expense
Fixed Charge Coverage Ratio
This measures a business’ ability to meet fixed charge expenses from its earnings before interest and tax (EBIT). Fixed charges are recurring expenses such as interest, lease payments (including principal) and wage payments, which need to be paid regularly in support of business operations. A higher Fixed Charge Coverage Ratio indicates that the business has more earnings to pay these recurring costs.
Fixed Charge Coverage Ratio = (Earnings Before Interest and Tax + Fixed Charges Before Tax) /
(Fixed Charges Before Tax + Interest)
It’s important to remember that profits aren’t the same as cash flow so being able to measure both is important when evaluating your business’ performance. Some common ways to evaluate profitability are:
Gross Profit Margin
The Gross Profit Margin of a business is calculated by subtracting Cost of Goods Sold (COGS) from revenue and dividing it by the revenue amount. As with any profit margin, higher is better and shows that there is more revenue, after COGS, available to cover overheads and hopefully contribute to profit.
Gross Profit Margin = (Revenue - Cost of Goods Sold) / Revenue
Net Profit Margin
The Net Profit Margin is a business’ net profit (after all expenses, including tax) divided by its revenue. The profit margin is used to show the proportion of revenues that were converted to net income. So a net profit margin of 0.2 means that for every $1 of sales, the company earned $0.20 of net income.
Net Profit Margin = Net Profit / Revenue
Return on Assets
This is a business’ net profit divided by its average total assets for the period, and indicates how well a business is using its assets to generate net income. A higher ratio tells the business owner that their business is using its assets more efficiently.
Return on Assets = Net Profit / Average Total Assets
Solvency and profitability will provide information on the ability of a business to operate and generate a return, but is also useful to see how cash flow and profits are generated. Efficiency ratios do this by examining relationships between a business’ revenues and its balance sheet (assets, liabilities, and equity).
These are also known as Turnover ratios and can measure how efficiently a business generates its sales.
Working Capital Turnover Ratio
The Working Capital Turnover ratio is sales divided by average working capital for the period and quantifies how efficiently a business is turning its working capital into sales. As with all efficiency ratios, the higher the ratio, the more efficiently a business is operating.
Working Capital Turnover Ratio = Sales / Average Working Capital
Total Asset Turnover Ratio
The Total Asset Turnover Ratio (sales divided by average total assets for the period) not only includes working capital but all assets on a business’ balance sheet. The main difference between the working capital turnover ratio and the total asset turnover ratio is that the total asset turnover ratio includes fixed assets like equipment and machinery.
This ratio is a measure of how many sales are being generated by a business’ total assets and a rising ratio is a sign that a business is improving the way it uses its assets.
Total Asset Turnover Ratio = Sales / Average Total Assets
Inventory Turnover Ratio
The Inventory Turnover ratio is the cost of goods sold divided by average inventory for the period and indicates how efficiently a business is using its inventory to create sales. A low and/or deteriorating ratio could indicate that a business is holding obsolete inventory that cannot easily be turned into sales.
This inventory could be taking up valuable storage space and potentially the value should be marked lower if it can’t be used as originally intended. Alternatively, a lower ratio could be a good thing if a business negotiated a great deal for a bulk purchase and that inventory will be used to generate sales in coming months.
Inventory Turnover = Cost of Goods Sold / Average Inventory
Quantify your business performance
Using the formulas outlined above, you can effectively measure and quantify the performance of your business and its overall financial health. Efficiency and profitability confirm your business’ ability to convert inputs into cash flows and net income, while solvency informs you how readily your business can cover longer-term debt and obligations.
As with all financial ratios, they are most useful when tracked through time as the trends can often identify issues that need to be addressed. Equally, they can indicate that your business through time is becoming lean, mean and super efficient!
If you're serious about running your business at it's potential, it's important to understand these ratios and the levers than can be pulled to improve them. When looking for a business loan, equipment loan or an equity investor, you can be sure that the capital provider is looking at these things so you should be too.
Earlypay offers invoice financing, equipment financing and trade financing for Aussie SMEs. If you would like to learn more about our services, please visit earlypay.com.au, or speak to your Broker or BDM.