SME Lending – Key Financial Ratios
In the classic UK comedy series, Little Britain, a recurring sketch theme revolves around the phrase “Computer says no”. In the show, it is a way for the lazy customer service officer to quickly dismiss a client and get back to Facebook or talking to their friend on the phone.
However, “Computer says no”, has real implications in modern business, where algorithms and pre-set calculations are used as a replacement for human interaction in decision making. This is more and more prevalent for lenders and investors who use common formulas and key financial ratios to evaluate small businesses.
As good, and as impassioned as your story might be, without the backing of strong business financials, your SME client may be rejected for their loan application – “Sorry – computer says no!”
As a business finance professional, you can add value to your SME clients by assisting them to focus on strengthening their key financial ratios. This will not only be beneficial to the general running of operations, but when it comes time for capital injection, the SME looks more attractive to potential lenders and investors.
Some of the more relevant ratios can be categorised into the following areas.
SMEs with poor profitability ratios may be unsustainable in the longer-term and therefore, unable to pay back debts or provide a return on investment for investors.
Operating Profit Margin
Operating Profit Margin = Operating Profit
SMEs can make a profit in a variety of ways, such as through the sale of assets or through their investments in non-core areas. However, it is important to calculate profit from the core business area and the cost to keep this core area functioning.
An SME’s operating profit margin is a good indicator of how well it is being managed and how risky it is. It shows the proportion of revenue available to cover non-operating costs, like paying interest, which is why investors and lenders pay close attention to it. Highly variable operating profit margins are a prime indicator of business risk. Looking at an SME’s past operating profit margins is a good way to gauge whether a big improvement in earnings is likely to last.
Net Profit Margin
Net Profit Margin = Net Income
Also referred to as the bottom line, this ratio answers the question – “Is there sufficient profit after all business expenses, including taxes?” Sometimes sales and gross profit can be misleading. A business with impressive sales growth, but with expenses that are increasing at a greater rate will have a lower net profit margin over time. Such a trend is a bad sign for lenders, investors and the business in general.
Return on Assets
Return on Assets = Net Income
Return on Assets (ROA) measures the ability of an SME to utilise assets/economic resources to generate income. Where the purpose of lending is to invest in additional assets, this ratio is one that lenders will analyse. They want a measure of how well a business puts its assets to use.
ROA can vary from business to business. However, a ROA of 5 -10% is usually deemed acceptable.
Meeting financial obligations can be a short-term or even immediate requirement of an SME. Liquidity ratios provide lenders with a measure of how fast a SME can turn assets into cash to pay bills that are due.
Current Ratio = Current Assets
Current assets can be defined as assets on the balance sheet which are 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 crucial to businesses because they are the assets 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 to be paid or settled in cash within a year. Examples of current liability are accounts payable for goods, outstanding expenses etc.
Also known as Working Capital Ratio, Current Ratio is a measure of the ability to convert short-term assets into cash to pay current liabilities. Lenders use the current ratio to help them determine the capacity to repay a potential loan; the higher the ratio, the better.
Quick Ratio = Current Assets - Inventory
The quick ratio or acid test ratio is a more stringent liquidity ratio that measures the ability of a company to pay its current liabilities when they come due, with only quick assets. Cash, cash equivalents, short-term investments or marketable securities, and current accounts receivable are considered quick assets.
Where the quick ratio is extremely low, lenders consider the probability that small impacts on cash flow can result in the SME’s inability to make monthly debt repayments or default altogether. This ratio is even more carefully analysed for very short-term loans or those collateralised against business financials or invoices.
Debt-Service Coverage Ratio (DSCR)
DSCR = Net Operating Income
Annual Debt Service
Lenders look at the debt-service coverage ratio (DSCR) to compare a SME’s annual net operating income to its annual debt servicing (including principal and interest), measuring its ability to service debt. It is commonly used for term loan applications and helps lenders work out the maximum loan size based on the cash flow generated by the SME. In general, lenders look for DSCRs of at least 1.25.
Cash Flow Ratios
A common factor of the above ratios is cash flow. Determining how much cash is generated and how it is used for investment, reserves and debt repayments is a key determinant of healthy and sustainable operations. The following ratios are also useful and used by lenders and investors.
Cash Flow to Sales Ratio
Cash Flow to Sales Ratio = Operating Cash Flow
This ratio measures how a SME uses operating cash to generate sales. Operating cash is the inflows and outflows that relate only to a business’s core business operations and does not include items such as depreciation.
From a lender’s perspective, an increasing cash flow to sales ratio is ideal. However, a steady ratio over time is also a sign of a viable business.
Free Cash Flow Ratio
Free Cash Flow Ratio = Operating Cash Flow – Capital Expenditure
Operating Cash Flow
Capital expenditures such as, property purchases or equipment acquisitions are taken away from operating cash flow to determine cash that is free for use in a SME.
Large free cash flow ratios indicate that an SME has the capacity to make capital improvements, provide investor dividend payments or is well placed to handle cash flow crises and continue to meet lenders monthly repayments.
Short-Term Debt Coverage
Short-Term Debt Coverage = Operating Cash Flow
Sometimes used as an alternative to the quick ratio, short-term debt coverage looks at a SME’s ability to meet the most immediate liabilities with cash from core operations (free cash). Again, the larger this ratio, the more satisfied lenders will be.
As a rule of thumb, lenders will use around 75% of the value of eligible receivables into a SME for the calculation of an asset-backed loan amount. Therefore, the more efficient a SME is at collecting payments from their customers, the better.
Accounts Receivable Turnover
Accounts Receivable Turnover = Sales
Where the accounts receivable turnover is low, a SME may have a problem with collecting outstanding debts. More diligent follow-up procedures may help, as could credit screening of customers. Improvement of this ratio over time could be a sign that changes in procedures are working, which may appease appraising lenders.
On the other hand, a high accounts receivable turnover may be a result of too strict credit policies that have resulted in the loss of sales.
Days Sales Outstanding
Days Sales Outstanding = 365
Accounts Receivable Turnover
This ratio shows how many days a SME’s clients are taking to pay their bills. It is compared to the credit terms of the SME. If the SME has a 30-day payment policy and days sales outstanding is 27, then things are good. If the figure comes in at 36 then this could be a sign of trouble. Lenders want to know if the SME you are working with can actually collect payments within the terms they set out.
These are some of the ratios used when appraising and evaluating SMEs. The initial and ongoing trend analysis of them provides the basis for good business decision making and gives lenders the information they need for their application approvals or denials.
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.