What are Financial Ratios?
One of the least favorite subjects for small business owners is financial analysis.
Most, of course, do understand whether they are “making money” but even here, owners sometimes are not clear about the difference between cash flow, profit and loss and other financial statements. It’s not good enough that your accountant understands these statements, even if she is a good communicator and talks to you often.
Most on going daily decisions you make are impacted by the financial condition of your business. Therefore it is imperative that the owner himself understands the financial make up and condition of her or his business.
Fortunately there is a solution to this problem.
First, you have to have some understanding of financial statements. Although this may seem daunting for those with the non-financial background (and this is most owners), there is help. Talk to your accountant. It would be worthwhile to have him spend a few hours educating you on the difference between balance sheets, income statements and cash flow projections.
Take a course at your local educational institution or online. Also most good business plan programs develop these financial statements for you (you do have a business plan, don’t you?).
OK, so now we know a little bit about these statements, now what?
There are two major sources of financial information that pertain to your type of business.
There is a compendium of IRS data (anonymous, of course) called the Almanac of Business and Industrial Financial Ratios. This is compiled by Leo Troy and consists of millions of sets of IRS data. The second source is called “RMA” and is based on an equally massive amount of lender data.
Both of these reference sources are broken down by business size. They are expensive to purchase but are available at the library.
How do they help you?
You can compare how your business is doing financially with all the other businesses in your industry. For example, a sales/receivables ratio will tell you how frequently your accounts receivable are paid compared to your industry. A current asset to current liability ratio compares your ability to pay current obligations compared to your competitors.
A cost of sales to inventory ratio determines how you are doing in turning your inventory in a year. You can compare your operating profit percentage to that of other companies.
You can compare how much debt you have relative to industry standards. You can even see what your industry average is for advertising expense.
There are over 50 ratios that you can compare to the average of other companies in your industry.
Even if you feel “financially challenged”, with a little training you can learn to understand how your business is doing financially compared to the rest of the businesses in your industry.
Maybe you have more inventory, more debt, less profit, or slower receivables than average for your industry. Maybe you’re better than average. For the financial health of your business, this is important information.
Don’t be afraid of not knowing enough about this financial stuff. It may take time, but you can learn this. Use these ratios in these two sources. You and your business will be better for it.
This article was written by Seattle SCORE Chapter member Fred Parkinson for the Kitsap Sun in Bremerton.