Planning: Financial Ratios

Financial ratios are usually part of your business financial plan and a part of the analysis of your business performance.

Ratios are particularly useful to measure business performance in comparison environments; e.g. in comparing your business' performance over periods of time (years, months, quarters) or in comparing to competitors in the same industry.

Some industries study ratios and comparative performance and provide that information (usually at a cost) on request. Check with your industry or trade association (the right type of association for collecting industry data) to see if they can refer you to a ratios study for your industry.

First, there are many ratios to use and analyze. And they can be categorized into a number of specific areas.

This is a sample of only some of the ratios you need to calculate and keep current - particularly if you're borrowing money, but also as a measure of how you do within your industry - industry analysis and review is a good way to build strategy (and there are a number of public companies in any industry, check their annual reports and compare how you do against them).

Financial Ratios by Category: including a formula for calculating at least one in each category

• liquidity ratio (such as, current ratio - a measure of the relationship of current assets to current liabilities (ability of your business to generate cash for short term demands): current asset divided by current debt;

• efficiency ratios (e.g. inventory turnover ratios, accounts receivable collection period ratio: which is # of days per year(365) divided by accounts receivable turnover; fixed asset ratio);

• profitability ratios (such as, gross profit margin ratio: which is gross profit divided by total sales; net profit margin ratio, return on assets, return on equity, and more);

• solvency ratios (such as debt to equity: total liabilities or debt divided by total equity; debt to assets, interest coverage, and more);

• operating ratios, (such as sales revenue divided by number of employees; fixed asset turn-over, and more).

Second, it is important to recognize when and why you should use these financial ratios (and it is not only to include them in your financial plan, it's also to include in your strategic business plan).

• Calculating and analyzing ratios is a good way to interpret the many numbers you see in financial statements.

• If you are borrowing money for your business from your bank or a lending institution, they will often tell you what their target ratios are: when your business does better or worse than those target ratios, the bank will pay attention.

• From a business managing perspective, ratios condense the financial information available into a short summary:

• Are your customers paying on time or are receivables far behind your plan?
• Are your operating expenses too high compared to the rest of your industry?
• Is your debt to equity too high - can you pay off short term debt from short term assets if necessary?

These are just a few examples of how you can use ratios to tell you how your business is doing, and where the strengths and weaknesses are.

Analyzing your financial statements by using financial ratios will help you to focus on specific business issues. During your business financial plan development, include the ratios you want to use and analyze.

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