Financial ratios allow you to evaluate your business’s performance, compare it with other similar businesses in your industry and uncover areas needing improvement. Ratios are used to gauge solvency, liquidity, operational efficiency and profitability of your business. Internal and external users rely on financial ratio analysis to get an in-depth understanding of a business’s financial position. Internally, it can be used by business owners or managers to monitor performance and pinpoint strengths and weaknesses from which new strategies, initiatives and goals can be formed. Externally, it can be used by financial analysts, investors, creditors, suppliers, banks, business brokers and potential buyers to gauge the future profitability and liquidity of your business.
While the advantages of making use of financial ratios are apparent, it is important to remember that no business operates within a “bubble” and as such, a number of external elements will make certain ratios more or less useful depending on the economic climate, government actions and market sentiment. A few important factors to take into consideration when analyzing financial ratios are as follows:
- No two businesses are the same and so the way you interpret their ratios should reflect what sector they operate in and their size.
- A business can change overnight which can render analysis of their historical performance irrelevant.
- Many businesses are impacted by seasonality factors and not factoring this into the analysis can lead to a false interpretation of the results.
- Financial statements are often manipulated to show a position which is better than the actual and any ratios calculated on such financials will also result in an incorrect analysis of the business.
Financial ratios can be broken down into four main categories: 1) profitability, 2) liquidity, 3) operating, and 4) solvency ratios. These ratios all work together and need to be applied and combined with other metrics in order to properly evaluate and analyze a business to get a complete picture of its’ financial performance and prospects. We will be taking a closer look at these financial ratio categories in upcoming articles to ensure you have the necessary tools required to keep your business’s financial health in check.