Learn 3 simple business ratios to identify negative trends in your business in less time than it takes to read your favourite newspaper.

Business ratios are tools that help you in evaluating the current performance of your business.  They are also very effective in helping you detect problem areas within your business before they get out of hand.  Business ratios are mathematical relationships between different items in the financial statements.  They are quite simple to calculate and learn, but require that you have some basic knowledge about financial statements.  

Today we will discuss three different types of business ratios, although there many more types that are used in business analysis on a regular basis. 

Liquidity ratios.  These types of ratios measure the ability of a business in meeting its short-term obligations.  One major business ratio under this category is the current ratio, calculated as follows: 

Current ratio = Total Current Assets / Total Current Liabilities 

The higher the current ratio, the more capable the business is in meeting its short-term obligations.  A current ratio which is lower than 1 usually indicates that the business is not able to meet its short-term obligations when they fall due.  Although a low current ratio is not a sign of good financial health, it doesn’t necessarily translate into bankruptcy because there are many different ways that a company can secure short-term financing to meet its emergency needs. 

Leverage ratios. These types of ratios measure the degree to which a business is financed by debt.  One major business ratio under this category is the debt to equity ratio, calculated as follows: 

Debt to Equity ratio = Total Long-Term Debt / Owners’ Equity 

A high debt to equity ratio usually means that a business has aggressively financed its growth with debt.  The risk in this is that the interest costs of the debt will not be covered by the return that is generated by the growth. 

Activity ratios.  These types of ratios measure how effective the business is in using its resources.  One major business ratio under this category is the inventory turnover ratio, calculated as follows: 

Inventory Turnover ratio = Sales / Inventory 

The inventory turnover ratio for a specific operating period essentially shows how many times a business’s inventory is sold and replaced in that period. A low ratio is usually an indication of poor sales or excessive inventories. A high ratio usually indicates a high level of sales or insufficient inventories to meet customer demand. For more information on how to read financial statements, take a look at my article “Impress your bank manager! How to read your balance sheet”.

Good financial management is essential to the survival and success of every business. 

Unfortunately, many small business owners have relatively limited exposure to financial management and are unaware of how strategically important it is to their business’ performance.

In general, financial management deals with the procurement of funds for a business and the effective use of those funds in the operations of the business.  It also involves using accounting numbers to measure the financial health of a business; to understand the reasons for the current financial position; and to make strategic decisions that will improve the general performance of the business.

The best way to demonstrate the importance of good financial management is to describe some of the tasks that it involves:

• Taking care not to over-invest in fixed assets         
• Ensuring that there is a sufficient level of short-term working capital to sustain and manage accounts receivables and inventory
• Setting sales revenue targets that will deliver growth
• Increasing gross profit by setting the correct pricing for products or services, reducing the costs of raw materials, negotiating supplier prices, and managing other factors that influence the costs of production or service provision
• Controlling the level of general and administrative expenses by finding more cost-efficient ways of running the day-to-day business operations
• Tax planning that will minimise the taxes a business has to pay
• Managing employee benefits
• Performing financial analysis using numbers generated from financial statements.

Good financial management begins with a solid book-keeping system that will allow for the production of accurate financial statements.  It requires knowledge of how to use the figures in the financial statements to the business’s advantage. 

For example, a good financial manager should know that a positive net profit and an increase in sales does not automatically translate into financial success.  If the business’ borrowed capital has increased at a rate higher than the increase in profits or sales, it means the company is financially worse-off than it previously was. 

Are you and your management team aware of this? 

There are many other strategic mistakes that managers who are unfamiliar or untrained in financial management make.  Over time these mistakes can become detrimental to a business’s success and survival so it is crucial that you learn as much as possible about how to financially manage your small business. 

If you have trouble with this, you may want to consider soliciting the services of a professional who knows the ins and outs of the process.

For more information on financial management, have a look at my article “Impress your bank manager! How to read your profit and loss account report”.