Understand how core financial ratios communicate essential information
Businesses need a sound system of analyzing their financial information to serve as an early warning of potential financial difficulties. The financial statements will provide them with periodic information on the overall health of the business, but when profits decline or cash is short businesses need a way to hone in on specific areas of the business that are causing these problems. Ratio analysis is the process that business, both large and small use to act as a barometer of the business’s health. These ratios often measure the relationship between two or more components of the financial statements. They are used most effectively when results over several periods are compared.Ratio analysis not only allows managers and owners to evaluate their performance period to period, but also compare their results with specific companies in their industry or the industry as a whole.
For ratios to be useful and meaningful, they must be:
- Calculated using reliable, accurate financial information (does your financial information reflect your true cost picture?)
- Calculated consistently from period to period
- Used in comparison to internal benchmarks and goals
- Used in comparison to other companies in your industry
- Viewed both at a single point in time and as an indication of broad trends and issues over time
- Carefully interpreted in the proper context, considering there are many other important factors and indicators involved in assessing performance.
There are 12 key financial ratios that businesses use to assess their performance. These ratios are grouped into four categories, measuring four dimension of a business’s financial status: liquidity ratios, leverage ratios, operating ratios and profitability ratios. All of these ratios can be calculated using the company’s key financial statements.