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Hard Times Call For Hard Numbers - Using Financial Ratios
Bob Ryan, About Purpose, Inc. ©2002
Whether the events of 9-11 and the tough economy have "laid you low" or sent your business skyrocketing, you need to get a solid handle on your finances. There's no easier way to do this than through key financial ratios.
Do you do your own books? Great, then getting the numbers you need to work with ratios is really simple. You just need your Balance Sheet and your Profit & Loss Statement. Do you have an accountant? Then s/he should be able to provide you with what you need in an instant.
Just get the numbers. Most entrepreneurs have, at best, a tenuous understanding of their financials. Many confess to me that they really don't get much out of the monthly (quarterly?) numbers their bookkeeper or accountant feed them. Many rely completely on their accountant to help them make financial decisions.
Here's a clue. No one knows your business better than you. Not your bookkeeper, not your banker, not your business consultant, not your brother-in-law. They may understand numbers better than you do, but the financials are only tools for decision making on a broader scale.
You need to understand and use your financial data. Gathering and using financial ratios is a great start. They aren't the complete picture, but they are very much like watching the dashboard on your car. They give you valuable information on an ongoing basis so that you can make decisions about speed, maintenance, direction, efficiency, etc. Like the gauges, if something gives you a funny reading, you know to check it out further. But without the gauges, by the time you learn there's a problem, it may be too late.
Here are three steps to getting hard numbers with financial ratios.
- Identify three to five ratios that are good gauges for your business. Your accountant or business consultant can help you to pick the right ones for your business.
- Collect them quarterly, at least, and better yet, every month. Track them over time and discuss their significance with your management team. Watch for changes and trends and interpret them for use in your strategic and operational decision making.
- Get industry data for comparisons and benchmark your business against others in your industry. Check first with your own professional association. Other resources can be found free at the library or for a cost, on-line. (Two resources that cover many industries are Industry Norms and Key Business Ratios from Dun Bradstreet and Service Industries USA: Industry Analyses, Statistics and Leading Organizations from Gale Research.
Here are several common ratios that tend to fit most for-profit businesses.* That doesn't mean they're right for you, but they're likely to be a good start. I also included how to figure them (in italics) and what they mean. Remember, ratios are expressed as fractions like 3/4 or 2/1.
Current Ratio - Current Assets / Current Liabilities: Your ability to pay your current obligations with cash and items that can easily be turned into cash. A higher number is better, to a point.
Quick Ratio - (Cash + Receivables) / Current Liabilities: Another liquidity measure, but this one measures your ability to pay your obligations in a more conservative way. More is better here, as well.
Profit Margin Ratio - Net Profit / Sales: How much money are you making for every dollar in sales? If this ratio is shrinking while sales hold, look at costs.
Receivables Turnover - Sales / A/R: Tells you how many times a year your A/R turnover. Divide the answer by 365 and you get how many days old your A/R is on average.
Debt Ratio - Total debt / Total assets: A high ratio indicates you have financed a substantial portion of your business. Danger sign if net sales are not enough to meet debt and interest payments.
Return on Total Assets Ratio - Net income / Total operating assets: This indicates the rate of return generated by the assets of your business. Dropping ratios could indicate poor utilization of your plant and operating equipment.
*(Call me if you are a not-for-profit, the key ratios are slightly different.)
Does all this make your head swim? Then just start out with one or two key ratios. As soon as you understand how those work, add a couple more. In no time at all, you'll find you have more confidence in making decisions, you'll know better what's important to spend your time on, and you'll get more out of the dollars and time spent with your business advisor or accountant.
Making hard decisions in hard times takes hard numbers. But getting and understanding them is easy.
E-mail me at bobryan@AboutPurpose.com