Significance of Financial Ratio Analysis to Micro, Small, and Medium Enterprises (MSMEs)

What are MSMEs?

Micro, Small, and Medium Enterprises (MSMEs) are likened to the backbone of the Nigerian economy. These enterprises range between a diverse array of businesses who operate at varying scales. From the little street kiosks around you, to e-commerce businesses that you may have interacted with in the not too distant past, to technological driven start ups, to established manufacturing units and so on.

These enterprises across board account for a larger proportion of revenue and employment generation in the economy when compared to larger corporations. I bet this gives you as a MSMEs business owner, an insight to the kind of impact you have on your immediate economy.

Although MSMEs may not match up individually to the revenue power or resource capacity of these larger corporations, MSMEs can leverage financial ratios to gain critical insights into their operations. 

This blog post is crafted to give you an insight into financial ratios and how they can be of help to your business. It will also provide you with a deeper understanding of the possibilities and features Tyms has to offer as it automates your bookkeeping and accounting process.

So In this blog post, we will be scratching the surface and getting an introductory view into the world of financial ratios and how they can be of benefit to MSMEs in gaining insightful information on their businesses, and also illustrating how these metrics can be a game-changer in decision-making and long-term planning.

We will be focusing on a few key financial ratios, these ratios are key in Visualizing your business’ short term viability, Maximizing returns, and Enhancing performance efficiency.

What are Financial Ratios?

Financial Ratios are Key Performance Indices created with the use of numerical values extracted from a business' financial statements (In this case, MSMEs).

These values are extracted from the financial reports such as: The statements of financial positions, income statements, and cash flow statements of the business, that can be automatically generated from Tyms book when it automates your books of account, are in turn used in mathematical calculations that help evaluate various aspects of a business financial performance and gain meaningful information about the business. These ratios assess a company’s liquidity, profitability, solvency, efficiency and many more.

In a nutshell, when talking about Financial ratios, they are simply financial figures used to gain meaningful insight into the financial performance of a business. For the purpose of this post, our focus is going to be on these three ratios:

1. Liquidity Ratios, 

2. Profitability Ratios, and 

3. Efficiency ratio.

Liquidity Ratio

Liquidity ratios basically are financial ratios used to evaluate your business ability to meet its short-term obligations with its current assets. It shows an insight in your business ability to pay up its short term obligations without having to borrow or source for external sources of income. This gives you an insight to how close your business is to winding up without disposing of illiquid assets, borrowing or any other source of external funding that may or may not be available to your business.

There are several commonly used liquidity ratios but for the purpose of this post, we will be looking into:

1. Current Ratio: 

This accounting ratio measures a business ability to pay off its short term debt obligations with its current assets, including its short term liquidity position. The Current Ratio of a business is derived with the following formula: 

Current Ratio = Current Assets / Current Liabilities  

A higher current ratio is generally considered better, as it indicates a stronger ability for you to meet your short-term obligations. Tyms provides you with your total current assets and liabilities from your books of account. Your current assets and liabilities are collated and displayed on your statement of financial position.

2. Quick Ratio or Acid Test Ratio: 

This financial ratio is used to measure the ability of your business to pay off its short term liabilities with its short term assets. This Ratio is similar to the current ratio but it is more conservative as it does not take account of short term assets that cannot be disposed of within 90 days or three months, such as inventory in most cases as it assumes Inventory might not be easily convertible to cash. 

The formula to derive the Acid test ratio for your business is;

Acid Test Ratio =  (Current Assets - Inventory) / Current Liabilities 

Tyms already sorts out the hassle of tracking your business inventory, it enables a more seamless process in filtering your inventory from your current assets.

If the quick ratio is > 1; the company has enough liquid assets to cover its current liabilities. A quick ratio that is = 1 indicates that the business liquid assets are just enough to cover its current liabilities. While a quick ratio below 1 suggests that the business may have difficulty meeting its short-term obligations with its readily available assets.

Profitability Ratios

Profitability ratio focuses on Maximizing business profits. They assess a business ability to generate profit from its operations, assets and shareholder equity. They provide an insight into how efficiently a business is utilizing its resources to generate earnings. There are several Profitability ratios used to assess the profitability and viability of a business. But we will only be looking at;

1. Net profit Margin: The net profit margin measures the percentage of your business revenue that remains as profit after all expenses, including taxes and interest, have been deducted. It simply measures how much net income or profit is generated as a percentage of revenue.
   Net profit Margin is derived by dividing your net profit from your total revenue and multiplying the answer by 100. A higher net profit margin indicates better profitability.

2. Return on Investment: This financial ratio shows how efficiently a business generates profits from its assets. it evaluates how effectively a business uses its total asset in profit making and how well it is deploying its scarce resources.

Return on Investment = (Net income / Total assets) * 100

Efficiency Ratio

Efficiency ratios are financial metrics used to assess how quickly inventory is sold and replaced. it reflects how effectively a company is utilizing its assets and resources to generate revenue and manage its operations. These ratios provide insights into the operational efficiency and effectiveness of a business.

In a nutshell, efficiency ratio measures the revenue generated by the business in comparison to the expenses made to produce that revenue. The efficiency of a business can be evaluated using;

1. Account Receivables Turnover: This ratio measures how many times on average it takes for a business to recover debts owed to it between a certain period. It simply measures the business Trade receivable rate.

Account Receivable Turnover = Net Credit sales / Average Account Receivable

A higher turnover indicates effective management of accounts receivable.

2. Account Payables Turnover: Similar to accounts receivable turnover is the account payable turnover, it simply is a financial ratio that measures how efficiently a business manages its payables. It's calculated by dividing the total purchases made on credit by the average accounts payable during a specific period.

In essence, Account payable turnover = (Total purchase made on credit / Average Account Payables)

A higher turnover ratio typically indicates that a company is paying off its suppliers more quickly, which can be a sign of good financial health. 

For a comprehensive analysis, businesses should strike a balance between these ratios. They give an insight into how many times on average within a given period it takes for your account receivables to pay up and and for you to pay your account payables.

Comparing them to industry peers provides valuable insights, helping identify any significant deviations that may require further investigation. These ratios also play a crucial role in managing cash flow and working capital. 

Tyms allows you to automate your book- keeping and accounting process. It enables you to keep your financial records seamlessly, and help with generating crucial financial reports like balance sheets, income statements, and cash flow statements for your business.

In assessing the financial health of your business with financial ratios, these statements provided by Tyms are crucial. Once you’ve gotten these crucial data from your Tyms account, calculating basic  Liquidity, Profitability and Efficiency ratios for your business wouldn't be a lot of trouble.