In order to assess how your business is doing, you’ll need more than single numbers extracted from the financial statements. Each number has to be viewed in the context of the whole picture.
For example, your income statement may show a net profit of $100,000. But is this good? If this profit is earned on sales of $500,000, it may be very good; but if sales of $2,000,000 are required to produce the net profit of $100,000, the picture changes drastically. A $2,000,000 sales figure may seem impressive, but not if it takes $2,000,000 in assets to produce those sales.
The true meaning of figures from the financial statements emerges only when they are compared to other figures.
Such comparisons are the essence of why business and financial ratios have been developed. Various ratios can be established from key figures on the financial statements. These ratios are very simple to calculate — sometimes they are simply expressed in the format “x:y,” and other times they are simply one number divided by another, with the answer expressed as a percentage. However, these simple ratios can be a powerful tool because they allow you to immediately grasp the relationship expressed.
When you routinely calculate and record a group of ratios at the end of every accounting period, you can assess the performance of your business over time, and compare your business to others in the same industry or to others of a similar size. By doing so, you won’t be alone — banks routinely use business ratios to evaluate a business that’s applying for a loan, and some creditors use them to determine whether to extend credit to you.
When you compare changes in your business’s ratios from period to period, you can pinpoint improvements in performance or developing problem areas. By comparing your ratios to those in other businesses, you can see possibilities for improvement in key areas. A number of sources, including many trade or business associations and organizations, provide data for comparison purposes; they are also available from commercial services. Your accountant may be a good source of information on how your business compares to similar ones in your particular locale.
There are dozens and dozens of financial ratios that you can look at, but many will have little or no meaning for your business. In the following sections we’ll concentrate on those that are most commonly considered to have the most value for making small business decisions. The ratios fall into four categories:
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