Using Financial Ratios

Using Financial Ratios

How can you measure the success of your business? Financial ratios can objectively tell you the story of your business. Learning how to analyze your financial statements and calculating financial ratios comes first. There are a variety of financial ratios to consider for your business. We previously wrote about each of the four main categories of financial ratios. These categories are efficiency, solvency, profitability, and liquidity ratios. 

After you calculate your ratios, learn how to put your analysis and financial ratios into action.  This assessment can help you understand the areas where your business is excelling or underachieving. Using insights from the analysis of your financial ratios you can set goals to help you grow your business. 

 

1. Determine which ratios are relevant

First, determine which ratios are relevant. Each ratio gives different insights into your business. How you use them will then depend on your specific goals.

If you have a goal to increase capital, pay attention to your net profit margin. The higher this ratio, the more likely you are of obtaining the financing you need. However, if your business relies on moving inventory, you might be interested in shortening your inventory turnover ratio. After all, the longer the inventory sits on your shelves, the more it costs.  This ratio enables you to see where you might improve your buying practices and inventory management.

Some ratios are more important in specific industries. For example, in a physical therapy practice, you should pay particular attention to the price per visit by the number of clients seen. The higher this ratio the more profitable the practice is and more valuable for potential buyers. Whereas, in a construction company, you may want to look at sales to inventory also known as inventory turnover. If this ratio is high it may indicate sales are being lost because inventory is understocked and/or customers are buying elsewhere. A low ratio may show there is not enough demand for the stock you are carrying. 

It is important to know which ratios are important to your industry. If you need advice on what ratios to consider, please feel free to contact us.

 

2. Track ratios overtime

After you decide which ratios are applicable, compare the results over time. This will allow you to see trends or changes in the performance of your business. Comparing previous quarters or years can help you identify problems to fix and direct attention to potential problems to avoid. Ideally, reviewing your ratios on a monthly basis will help keep you on top of changing trends in your company. 

 

3. Benchmark your business

Knowing how your business compares to others in your industry can be very valuable. This can give you a general sense of where you should be. There are many tools for benchmarking your company. Using these tools, see how you compare to your competition. By comparing your business to those of competitors you can identify your strengths and weaknesses.  Then set realistic goals for improvement in your company. 

Keep in mind there is no “magic number” you should be striving for. Every industry is different, not to mention a number of other factors that may impact it. These factors may include location, size, and various costs. If you would like to know specific factors for your industry that impact the value of your business please reach out

 

4. Obtain financing

Bankers, investors, and analysts all assess financial ratios. They often ask about your business’s financial ratios and how they compare to benchmarks in your industry. Ratios assist a person in learning about a company’s current financial health as well as its potential. Insights such as too much debt, high inventory levels, or slow accounts receivable are valuable indicators. As such, a small business’s ability to obtain debt or equity financing will often depend on the company’s financial ratios.

 

5. Drive your strategy

Lastly, financial ratios can be an important tool for small business owners and managers to drive strategy. Knowing your financial ratios can help you measure your progress toward reaching company goals. The insights that come from financial ratio analysis should shape the direction of your business and its strategic plan. By addressing your business’s current weaknesses you can create a strategy to become more competitive and profitable. 

 

Using financial ratios strategically can help you end up with a better, more profitable business. If you are not sure which ones are right from your business, or how to use them, Peak Business Valuation is here to help you. Our experts can help you focus your energy on areas that will maximize your company value. Questions are always welcome. Please reach out via email or through a phone call.

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