For the small businessperson, number crunching can be mind numbing. However, becoming conversant with a few core concepts can help you get an accurate view of how well your firm is doing. One of the most useful of these concepts is financial ratios.
Use and Limitations of Financial Ratios
Ratios can tell you how your company is doing, by depicting relationships among your financial statements. The comparisons are useful for determining how well your business is performing, and spotting indicators that show where it is strong and where it is weak.
Ratios are important for you to know about because people who can financially impact your business rely on them, including bankers, investors, creditors, and business analysts. If you need financing or a loan — and at some point many businesses do — your company’s financial ratios will likely come into play.
A financial ratio analysis can help potential investors make a decision about the long-term profitability of your company and as an investment opportunity. They are useful for your creditors as well when they are trying to decide if it is wise to extend you more time to pay or to allow you to buy further supplies or services from them.
These ratios are also a very handy tool for you and your management team to gain an understanding of how well you are doing in your local market or compared to others in the industry as a whole.
A ratio is a comparison based solely on a mathematical analysis of proportions, so the size of the firm does not matter. Doing these calculations lets you easily examine relationships between categories on your financial statements and then measure them. This means it is a practical way for large and small companies to compare data.
When you can compare your company, whatever size it is, to others across industries, you can more quickly spot strong and weak points and measure your progress. It can help you adapt your company efforts to make the most of current trends.
We base ratios on raw mathematical data, and they are relevant only for the period covered and the data found in the originating financial statements. They are also subject to the accounting methods used. This gives them power, but it also limits their usefulness.
Ratios do not give you all the information you need for major decisions. Ratios will never replace experience. They are a tool and not a replacement for, a skilled, adept business owner. They do not include intangibles such as a once-in-a-lifetime chance to move ahead, the vagaries of the current marketplace or the interplay of your management team or other industry power brokers. In many cases, one lone financial ratio does not paint the picture that several can when combined and analyzed.
Just about any item on financial statements can produce a ratio, but some offer more insight to the small business owner. Essential ratios are liquidity, asset turnover, financial leverage, and profitability.
Liquidity ratios reveal whether your company can meet its short-term expenses, which makes them of particular interest to your creditors. The current ratio is a common liquidity ratio. Its equation is:
Current ratio = Current Assets/Current Liabilities
A high current ratio is attractive to creditors because it shows that, if they choose to do business with you, their risk is low. On the other hand, your shareholders will prefer that you keep a lower current ratio because this indicates that you are keeping your assets at work in growing the business.
Two other liquidity ratios commonly used are the quick ratio and cash ratio. The quick ratio makes the calculation more accurate if you have inventory that is hard to liquidate. That equation is:
Quick Ratio = (Current Assets – Inventory)/ Current Liabilities
There is also a conservative way to calculate liquidity ratios, which is helpful when trying to figure a company’s ability to pay its current liabilities immediately. Here is the cash ratio equation:
Cash Ratio = (Cash + Marketable Securities)/Current Liabilities
Asset Turnover Ratios
It is important to track how efficient your company is at using its assets to generate income. This is the purpose of asset turnover ratios, also called efficiency ratios. These ratios look at the timeframe involved in collecting cash from your customers or how long it takes you to convert your inventory into sales. These are often used with profitability ratios to tell how well a firm is doing.
There are a number of equations used for this ratio, including receivables turnover, average collection period, inventory turnover and inventory period.
Financial Leverage Ratios
If you want to know what the long-term prospects are for your company, you look at financial leverage ratios. These measure the extent that your firm is using long-term debt. It measures your overall debt load and then compares it with your assets or your equity.
This shows you how much of your company belongs to you, or to your shareholders, and how much to your creditors. When you or your shareholders own most of the assets, the company is called less leveraged. When creditors own the majority of assets, the firm is referred to as highly leveraged.
The two most basic equations for this are:
Debt Ratio = Total Debt/Total Assets
Debt-to-Equity Ratio = Total Debt/Total Equity
Profitability ratios measure the success of your business in generating profits. They focus on return on investment, or ROI, from inventory and other types of assets.
Investors and creditors are very interested in these numbers. It helps them to analyze resource and asset data to judge ROI and determine if the company is making enough profit from its operations. That is why these ratios get examined in conjunction with asset turnover ratios.
There are numerous equations used for these ratios, including gross profit margin, return on assets and return on equity.
The bottom line: All these numbers and calculations can be hard to grasp at first go-around. It might also seem they are remote from the day-to-day operations of your business. However, looking at what the pure numbers tell you, with the help of a skilled accountant or financial advisor, can help you make sensible, realistic changes today so your company will prosper in the future.