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Financial Ratios Definitions:

A Few Examples: Inventory Turnover Ratio and Cash Debt Coverage Ratio

Financial ratios are a way to measure business performance. To understand what inventory turnover ratio, cash debt coverage ratio or dividend payout ratio are, use ratios definitions. Ratios can be broken into five common categories: liquidity, market, activity, profitability and debt ratios.

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Financial Ratios Definitions

Ratios are usually part of your financial plan and need to be a part of the analysis of your business performance.

Ratios are particularly useful in measuring your 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, or similar, 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.

Analyzing Ratios

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 Definitions 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 (highlights the ability of your business to generate cash for short term demands): current asset divided by current debt;

  • Efficiency ratios (for example, inventory turnover ratio; accounts receivable collection period ratio: which is the number 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 (for example, debt to equity: total liabilities or debt divided by total equity; debt to assets, interest coverage, and more).

    Cash debt coverage ratio: shows the percentage of debt that current cash flow can eliminate or retire. A cash debt coverage ratio of 1:1 shows that the business can repay all debt within one year;

  • 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 ratios (and it is not only to include them in your financial plan, it's also to include your ratio targets 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 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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Additional Reading:

Return from Financial Ratios to Small Business Plan.

To manage your business effectively you need to focus on Calculating and Managing Profit.

Measure Your Business Performance regularly and consistency and compare to your goals and plans.

Ensure that your Business Financial Plan addresses seasonality and growth plans.

Your financial planning is dependent on effective management of Cash Flow and Capital Expenditures.

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But once you've built the plan, you must execute it.

There is no value in building a plan that just gathers dust.

When building your business plan, make sure that you include an action plan for the strategies, techniques and tactics.

The actions need to include who's responsible for doing what; measurements for success (such as deadlines and timelines, targets and goals, costs, etc.); and why you need to take the action (in some cases, one action needs to be accomplished before subsequent ones can be launched).

As you work through the plan, make sure that you build reporting periods into the implementation: you need to know what's going on and why something is working, or not.

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Balance your activities against the plan: make sure that you are investing your time, and money, on the elements of your business that will help you succeed.

Measure what works, and what doesn't work, and keep your focus: use your business plan as a map to guide you in the direction you want to go.