SME Lending – Key Financial Metrics
In modern-day sport, technology and statistics are playing an increasingly important role. Coaches, managers and talent scouts are constantly referring to factors such as heart rate, reaction time, bat speed and distance covered to gauge the worthiness of their current or potential team members. They also use this information to determine where they should invest time and energy to enhance the skills of their players.
Similarly, as a Business Finance Professional, you should be working with your SME clients to reference the performance metrics of their business to determine how they are positioned, what’s going well, what can be improved upon and what may need to be ‘dropped’ from their operations.
Lenders too, look at key financial metrics to determine whether they will ‘support’ your client’s team by providing finance. One of your primary roles is to help your client provide the lenders with information and understanding to support applications for finance.
In looking for the key financial metrics for a small business, four areas should be analysed.
Profitability
Liquidity
Leverage
Efficiency
1. Key Metrics - Profitability
Sales
To state the bleeding obvious, businesses don’t exist without revenue, let alone be profitable enough to be an ongoing and viable concern. The foundation of revenue is sales and is the centre of attention for good business finance professionals. It is also the first metric a lender will focus on.
All businesses are different, so it is important to analyse sales figures across the most appropriate time frames. Should it be monthly, fortnightly, weekly or even daily? The next critical step is to reflect on whether the sales numbers are where they need to be. Comparing actual sales against budget is a great method for maintaining focus on this key metric.
Gross Profit
Gross profit is the profit a business makes after deducting the costs associated with making and selling its products, or the costs associated with providing its services.
Gross profit measures how well a business uses direct labour and raw materials in producing goods or services. The difference between sales (Revenue) and the cost of goods/services sold (COGS) must be enough to cover the fixed overheads of a business in order to make a profit.
Again, all businesses are different with a range of fixed overhead costs. For some businesses, a gross profit of 20% of revenue may be sufficient to cover these costs. For others, the percentage may be in excess of 50%.
Sales and gross profit are tenably linked, and a break-even sales target will provide an accurate projection of the business’s gross profit.
Operating Profit
Operating profit is the profitability of the business, before taking into account interest and taxes. Operating expenses are subtracted from gross profit to determine the operating profit. Operating profit is a key number for SME owners to watch as it reflects the revenue and expenses they can control.
Operating profit and EBIT (earnings before interest and taxes) are the same.
EBITDA
It’s good to know a business’s operating profit, but the best profit measure is EBITDA.
EBITDA stands for Earnings Before Interest, Taxes, Depreciation, and Amortization and is a metric used to evaluate a business’s operating performance. It can be seen as a proxy for cash flow from the entire business’s operations.
EBITDA focuses on the operating decisions of a business because it looks at the business’s profitability from its core operations before the impact of capital structure, leverage and non-cash items like depreciation are taken into account.
2. Key Metrics - Liquidity
The liquidity measure of a business is the comparison of current assets against current liabilities
Current assets can be defined as an asset on the balance sheet which is expected to be sold or otherwise used up in the near future, usually within one year, or one operating cycle – whichever is longer. Current assets include cash, accounts receivable, inventory, marketable securities, prepaid expenses and other liquid assets that can be readily converted to cash.
Current assets are important to businesses because they are the assets that are used to fund day-to-day operations and pay ongoing expenses. Plant and equipment on the Balance Sheet are generally considered as non-current assets.
Current liabilities can be defined as those liabilities that are to be paid or settled in cash within a year or operating cycle. Examples of current liabilities are accounts payable for goods, outstanding expenses etc
It is generally accepted that a business with good liquidity will have around twice as many current assets as current liabilities. This is sometimes expressed as a ratio of 2:1. Having less than this could indicate a potential problem, because, although there is more working capital than debts, the cash flow cycle is imperfect. Stock can be slow to sell, suppliers can demand fast payment and customers can take their time paying their accounts.
3. Key Metrics - Leverage
To analyse the leverage position of a SME, business finance professionals compare the levels of debt of a business to the level of equity or private investment. While some debt is good, as it provides the ability to grow and expand, too much can be dangerous. High levels of debt can put a business at the mercy of lenders who are inflexible when it comes to meeting interest and principal repayments.
It is generally accepted that a higher proportion of equity to debt is advisable.
4. Key Metrics - Efficiency
Ageing Accounts Receivable
This metric tracks unpaid customer accounts. Some customers will pay their accounts on time, others will not. And it doesn’t matter if they are having problems or are just slack in paying on time – it’s the same result for the business – cash flow issues. A long ageing accounts receivable position isn’t looked upon favourably by lenders. Good collection procedures, that are the result of diligent analysis of this metric, can have multiple benefits for your SME clients.
Stock Turnover
Stock is a substantial investment for most businesses, so the fast turnover of stock into sales is healthy. The higher the stock turnover, the better since a high turnover typically means a business is selling goods very quickly, and that demand for their products or services exists. On the other hand, low turnover may signal weakening demand for business products or services.
To understand and have a good sense of the financial position of a client’s business, business finance professionals should analyse and monitor these key metrics. Not only will it help you advise your SME clients on ways to strengthen their businesses, but when it comes to considering finance methods, to pursue opportunities, decision making will have more clarity and certainty.
In conjunction with industry experts, elevateB has developed a self-paced, online, interactive Business Finance Certification. This program will provide you with the knowledge and skills required to become a successful Business Finance Professional and work in the SME space. In addition, it provides strategies and soft skills to assist you to better market and deliver your existing and new-found client offerings.
For more information on the Business Finance Certification, click here.