There are several important financial ratios a small business owner should know relating to the performance of their business. These include: Return on Assets, Return on Equity, and Times Interest Earned.
• Return on Assets – Indicates the profit generated by the total assets employed. A higher ratio reflects a more effective employment of company assets. This ratio is generally presented in terms of percentages.
• Computed as: Net Earnings / Total Assets
• Return on Equity – Indicates the profit generated by the net assets employed. This ratio reflects the stockholders’ return on investment as a percentage.
• Computed as: Net Earnings / Total Net Worth
• Times Interest Earned – Reflection of the company’s ability to meet interest expense from operations. Overall indicator of leverage balance
• Calculated as: Net EBIT / Interest Expense
I can’t stress the importance of understanding these performance ratios. Should your business need to borrow money from a bank or non-bank lender, it is very likely that the lender will calculate these ratios and make decisions based on the strength of these critical performance benchmarks.
Often lenders will require loan covenants which will require the business borrower to maintain certain financial benchmarks or the loan will be in default. If you are considering a loan that will have such covenants, understand the choice of the benchmark and the measurement will often be negotiable. The lender isn’t interested in seeing its borrower default, rather its intention is to make sure management is doing a good job with those benchmarks the lender consider most important. It is wise to negotiate provisions that if the company must miss their covenant benchmarks for at least 2 consecutive quarters before default.
There are many other types of benchmarks that a business owner can use to measure a financial aspect of his business, but for small business the benchmarks I have discussed here and in my prior post (liquidity ratios) are the most pertinent to businesses with revenues of less than $10 million.
It is wise to watch trends in a company’s benchmark over time. Some trade associations provide financial comparative figures that can be used to compare your business to your peers. This is especially valuable because industries can vary from one to another.
Your banker may also be able to provide you a print out of your industry ratios for comparative purposes. Most banks are members of the Risk Management Association (RMA) which is collects information from its member lenders on loans made and considered. The comparison data can be very useful. If your bank can’t help you with a copy of your industry’s figures, you can also purchase the data yourself from the RMA.
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