Use Ratio Analysis to Evaluate the Financial Health of Your Small Business
Ratio analysis in a small business? Really? Maybe you're familiar with the term or maybe you aren't. Perhaps you thought ratio analysis was only for the "big guys." Not so! Ratio analysis can be used very effectively in a small business to improve decision-making that leads to improved operations and higher profits.
What's the Purpose of Ratio Analysis?
The value of ratios is that they can be used to spot trends in a business, which can provide assistance in identifying a company's strengths and weaknesses in the areas being analyzed. Ratios can provide quantifying information on your company based on historical results, and can also be used to compare your company with other companies in the same industry.
How to Use Ratios
There are numerous ratios that can be calculated for practically any set of numbers on financial statements. Some are more appropriate to individual industries and businesses than others. Some ratios are quite complex while others are easier to understand. The trick to making the most of ratio analysis is to simply work with those ratios you feel most comfortable with and that will be most beneficial and applicable to your business.
There is no need to become a professional financial analyst. Your goal in using ratio analysis is to understand the benefits that will assist you in making future business decisions. There are no precise ratio measurements. This means that you cannot say that one ratio or another is unequivocally good or bad for your particular business. Generalized statements can be made for the various ratios, but the best use of ratios is to compare the current accounting period with previous accounting periods and industry averages if available.
The easiest and fastest way to benefit from ratio analysis is to understand the trend of the ratio you are calculating. Is it increasing or decreasing? Is it getting better or worse? Setting up a simple spreadsheet so you can see the trend of each ratio is a beneficial way to review these calculations.
The following five ratios can be useful to develop trends and evaluate the relative financial strength of your business in certain areas:
1. Current ratio – Divides current assets by current liabilities. This is one measure of your company's ability to meet current obligations. If the current ratio increases, it is generally an indicator that your company is better able to meet current liabilities.
2. Working capital – Current assets minus current liabilities. This ratio is a direct indicator of your company's ability to grow. This trend reveals whether your company’s working capital is increasing or decreasing, meaning "Are current assets increasing faster than current liabilities?" When this situation exists, then your company has more available capital to fund operations, purchase inventory, and so on.
3. Inventory turnover – Calculated by dividing the cost of goods sold by the average inventory balance. This ratio calculates the number of times the average inventory balance is sold during the accounting period. Stated another way, it answers the question "How quickly is my inventory being is sold." The more frequently a business can sell or turn over its inventory, the less capital it has invested in inventory, thus freeing up cash for other important business activities.
4. Debt to equity – Calculated by dividing total liabilities by total equity. This ratio indicates the relationship between company owners and creditors. It is a measure of the amount of protection provided creditors by owners. When the ratio increases, creditors assume a greater risk. In contrast, a lower ratio normally indicates greater long-term financial safety of a company.
5. Profit margin – Calculates net income divided by net sales. This ratio reflects a company's ability to turn sales into profit. It is a measure of how efficient a company is at producing sales and then turning those sales into net profit. Trending of this ratio from year to year is only one part of the analysis. Another great way to use the profit margin analysis is to research and compare the profit margin ratio of your business to industry norms.
Become familiar with ratio analysis and use its benefits to improve your business!
