times interest earned calculation tells us how able we are to meet the interest obligations to our creditors. It is calculated as follows:
Times interest earned = Earnings before interest and taxes (EBIT) ÷ Interest expense
If our earnings before interest and taxes (ebit) is $23,496 and our interest expense is $2,674, then the ratio is —
Times interest earned = $23,496 ÷ $2,674 = 8.8 times
This means we could have paid our interest expense almost nine times over. In general, the higher the ratio, the “safer” the business is. It is critical to note, though, that this ratio only looks at the interest portion of our creditor obligations, not the required principal repayments. The principal repayments are part of the current ratio (for principal repayments due in the next 12 months) and the total debt ratio (for all principal repayments).
Profitability ratios
The last major category of ratios is profitability ratios. These measure how effectively you are able to use your resources to produce profit. We will look at three ratios in this category:
• Profit margin
• Return on assets
• Return on investment
Profit margin
The profit margin is a common measure of how well you can translate gross sales into bottom-line profit. It is calculated as —
Profit margin = Net income ÷ Sales
If your sales are $113,423 and your net income is $22,475, your profit margin is —
Profit margin = Net income ÷ Sales
= $22,475 ÷ $113,423 = 19.8%
This tells you that for every dollar of sales, you are generating almost 20 cents in net profit. As you can well imagine, in general, the higher the profit margin, the better off the business.
Return on assets (ROA)
Your assets are what allow you to generate profit, and the return on assets ratio (roa) shows you how effectively you are using your assets to generate profit. It is calculated as:
ROA = Net income ÷ Total assets
If your net income is $22,475 and your total assets are $73,810, the roa would be —
ROA = Net income ÷ Total assets
= $22,475 ÷ $73,810 = 30%
You can also say that for every dollar of assets you have on the balance sheet, you generate 30 cents of net profit. The higher the ratio, generally, the more effective you are at using your assets to generate profit.
Return on investment (ROI)
Return on investment (ROI) is one of the least calculated and most important ratios for small businesses. It tells you what kind of return you are getting from the personal money that you have invested in your business.
For example, let’s say that when you started up the business, you took $7,500 from your savings account and used that money for start-up expenses. You could have taken that same money and invested it in a bond (where it would earn interest income) or in real estate (where it would earn rental income) or in one of many other investments. But you chose instead to invest in your own small business. Shouldn’t you be making a return on that investment? Absolutely!
In Chapter 12 we delve deeper into the issue of return on investment. For now, here’s how we calculate it:
ROI = Normalized net income ÷ Money invested
What do we mean by “normalized” net income? We want to calculate net income as if you are being properly compensated for the hours you work in the business. This is your “employee” or “manager” role. How do you know what you’re worth? Start by calculating how much you would have to pay someone else to step into your shoes as the manager of the business. For example, if you would have to hire a replacement for $47,000 and you are only paying yourself $25,000 in order to take it easy on cash flow, then you would subtract the difference ($22,000) from income to get to normalized net income.
ROI = Normalized net income ÷ Money invested
= ($22,475 – $22,000) ÷ $7,500 = 6.3%
This means that you are making a 6.3 percent return on your investment in the business. This is probably better than a savings account but not enough to compensate you for the risk of investing in a small business. On top of that, you’re getting paid $25,000 for a $47,000 job. You have a ball and chain around your ankle because you can never leave your business. You would have a difficult time finding someone to take over your business and make that kind of money. It is not a very cheery outlook!
Which Ratios Should My Business Track?
Whew! That’s a lot of numbers! You are probably wondering if you need to track them all on an ongoing basis. Of course not. Some ratios will be more applicable to certain businesses and certain industries than others. For example, if you provide a service instead of a product, the inventory turnover and return on assets may not be relevant to you, but the receivables turnover may be critical to the efficient operation of your business.
Choose the most important four or five ratios for your business and track those as part of your monthly management operating plan.
Case Study
“So, is this telling me,” Joe started, “that our receivables are outstanding for an average of 53 days?”
“That’s exactly what that tells you,” Vivian said.
“But our terms are net 30. That sounds like it’s a problem.” Joe picked up the paper and examined it closely.
“Now we’ll be able to figure out when we do have problems like this,” Becky said. “Vivian, how can we correct the accounts receivable problem?”
Vivian said, “First, let’s take some time and examine some of your other key ratios. Then we’ll have a better picture of all the issues we need to manage.”
When Good Ratios Go Bad: What to Do When There’s a Problem
Okay, so you have chosen the important ratios you want your business to track and you are tracking them on a quarterly basis. In the third quarter, three of the ratios seem out of kilter. What do you do? How do you know what’s going wrong?
Here is a quick guide to the questions you need to ask yourself and your team if your
