Is your business in good financial health? Check it with the help of ratios! Part 2

In my last post, I wrote about liquidity ratios. I have explained why I think they are the most important of all the ratios. Let me quickly remind you about liquidity. Liquidity means the availability of cash. It's essential for the survival of your business. The next most crucial element of business' health to keep an eye on is your business's financial position or financial leverage.

Interest cover ratio and Gearing

Some businesses are started with the use of owners capital only. Most businesses, however, use borrowed money to start, or expand their activity. Although borrowing money can be a great way of increasing business' working capital, you should be mindful of how much of your business' capital is debt. This is because debt comes at a cost. It creates a liability that needs to be repaid regularly in set amounts -usually monthly, regardless of whether your business makes money or not. In simple words, debt is a burden. It is important, that you, as an owner keep an eye on it, and make sure that this burden will not overwhelm your business.

When the proportion of debt to equity is too high you might expect that the loan payments will be too high. If that's the case, you will have limited options for using money from your profit. Instead of reinvesting money in the business, it will be continually going out of it and back to the bank. This is why it's important to make well-informed decisions while looking for finance. Calculating financial position ratios will help you with that.

Interest cover = profit from operations/ finance cost

Gearing = Non-current liabilities/Capital employed

The interest cover ratio calculates the proportion between the profit from operations and finance cost. Information that it gives us is a safety margin of profit over the finance cost. It means it tells us how well does the profit cover the cost of debt. This ratio considers the ability of the company to cover its finance costs from its profit from operations. The higher the interest cover ratio the better.

Gearing calculates the percentage of debt in the capital employed. It focuses on the business' balance and the long term funding of the company. We take into consideration all non-current liabilities, like debt, and working capital is calculated as all non-current liabilities and total equity. The gearing ratio of above 50% is considered risky, and banks are much less likely to give a loan to a business, which has such high gearing.

How to calculate these ratios?

Profit from operations

Profit from operations is your revenue, minus the cost of sales (purchases and inventories), and minus any direct expenses, that is expenses that are directly relating to the production of your products or delivery of your services.

Finance cost

Finance cost is the cost of your loan or debt. This is usually interest on your loan payment.

Capital employed

Capital employed is capital or equity plus non-current liabilities. It is called waring capital, because it takes into consideration all the money, that the business is using to finance its activities.

Non-current liabilities

These are all liabilities, that are due later than12 months from now.

Example:

Profit from operations = £ 40000

Finance cost = £1500

Non-current liabilities = £15000

Capital = £30000

Interest cover = 26.66

Gearing = 33.3%