Why don’t Small Businesses understand their Financial Ratios when banks rely on them?

Financial ratios are used by businesses of all sizes, to make comparisons between different aspects of a business’s performance or how the business stacks up within a particular industry or region. They reveal basic information such as whether you have accumulated too much debt, stockpiled too much inventory, or are not collecting receivables fast enough.

There are 4 important types of financial ratios, which are all calculated by comparing various values on your financial statements.

1. Liquidity Ratios: These ratios measure how much liquid assets (cash, easily converted assets) you have to cover any of your debts. There are 2 ratios: the Current Ratio, which is the ratio of Current Assets to Current Liabilities; and the Quick Ratio which is like the Current Ratio but does not include inventory in the calculation.
2. Efficiency Ratios: Often measured over a 3- to 5-year period, these give additional insight into areas of your business such as collections, cash flow and operational results. Inventory Turnover is the ratio of Total Purchases to Average Inventory, which tells you how often you refresh your inventory. Average Collection Period is the ratio of receivables to total sales. and tells you the average time it takes for your customers to pay you.
3. Profitability ratios: These ratios help you measure the financial viability of your business and compare your business’s performance to others in your industry. There are many types of profitability ratios, but the most important (and easiest to calculate) is the Net Profit Margin – the ratio of Profit to Revenue.
4. Leverage ratios: They indicate the long term solvency of the business, and tell you about how you are using long term debt.

Why are they important?

Financial ratios are important to know for two reasons.

1. They help you to understand your business’s financial health and identify how it may be improved.
2. As you may have guessed from the title, banks are very interested in a business’s financial ratios. This is because banks use financial ratios to make decisions on lending. Your financial ratios tell a bank how high their risk is if they lend to your business, so having strong financial ratios is important when borrowing money. The Leverage Ratios, in particular, are important to banks, because they tell the bank how well you are paying off your debts.

Why don’t small businesses understand them?

There are as many financial ratios as there are figures in your financial statements, and they all tell you something about your business’s performance. And since every industry is different, a “strong” financial ratio is also going to be different depending on what industry you are in. How are you, as a small business owner, supposed to manage this?

1. First, understand your industry. The ATO has a list of industry benchmarks which they update every year. https://www.ato.gov.au/business/small-business-benchmarks/ Even within the industry there may be variation in what is a good financial ratio, but the ATO benchmarks give you a starting point.
2. Work out which ratios are relevant to you. Some ratios are universally relevant, like the Net Profit Margin. Others depend on the type of business, like the Inventory Turnover.
3. Regularly monitor your ratios. For you to get any valuable insight out of your financial ratios, it is important to review your ratios to keep on top of changing trends in your company. Ideally this should be done monthly.
4. Get help from an accountant. Even after these steps you may still find it tricky to understand exactly what your financial ratios are telling you. This is OK! One of our accredited accountants can help you make sense of the numbers, and besides, having your financial statements audited by an accountant is also important for the bank to make lending decisions.