Creditors, business partners, current and prospective employees, and management have an interest in determining the financial stability of a small business. Changes in customer preferences, competitive landscape and macroeconomic factors strongly affect small businesses, because they usually do not have the financial wherewithal to deal with rapid changes. Determine the financial stability of a small business by examining its profitability, liquidity and overall debt levels.
Assess profitability, which is a key component of financial stability because profitable businesses generate free cash. Unlike large public companies, small businesses do not have ready access to the debt and equity markets to raise funds to make up for losses. The gross profit ratio is gross profit divided by sales, and the net profit ratio is net profit divided by sales. Gross profit is sales minus cost of goods sold, and net profit is gross profit minus all other expenses.
Look for signs of choppiness in the ratios, as they can indicate underlying financial problems. A stable business will show consistent gross and net profit ratios, and well-run businesses will show year-on-year growth in both sales and profits. For example, if the gross profit ratio is steady over time, but the net profit ratio is all over the map, there might be an issue in how the expenses are being managed. If sales grow by five percent, then gross and net profits should also grow by at least five percent.
Evaluate liquidity, which is the ability of a small business to pay its short-term bills. The current ratio is equal to current assets divided by current liabilities. Although small businesses are unlikely to have high current ratios, a ratio greater than one should be a good indicator of financial stability. Liquid businesses have more operational flexibility during tough economic times.
Calculate the accounts receivable-days ratio, which measures liquidity and managerial efficiency. The ratio is equal to 365 divided by the ratio of net sales to accounts receivable. A high ratio means that the business is not collecting its outstanding bills fast enough, which ties up valuable cash required to cover expenses. Accounts receivable tracks the amount of sales bought on credit that have not been settled in cash.
Determine the overall debt level, which should be low for a financially stable business. Two common ratios are the debt-to-assets ratio, which is total debt divided by total assets, and the times-interest-earned ratio, which is operating income divided by interest expenses. Operating income is sales minus operating expenses.
A financially stable small business should have a debt-to-assets ratio between zero and one -- anything greater than one indicates more debt than assets, which is not a healthy sign. A stable business should have a high times-interest-earned ratio, which indicates that it is comfortably able to cover its interest payments with its operating income.
Don't expect the same ratios from all small businesses. For example, the ratios of a well-financed technology startup and a small restaurant trying to compete with ready-to-eat meals and brand-name franchises will be different.