The current state of the economy is an experience in fortitude for many business owners. With rising gas and food prices and the upcoming minimum wage increase, it is inevitable that changes must be made to increase revenue or reduce expenses in order to survive. It is common to reduce advertising expense as a first line of defense. However, prior to making changes, it is wise for business owners to analyze their financial condition.
One analysis is a review of financial ratios.
There are three major categories of ratios: Liquidity, profitability, and efficiency.
Liquidity ratios help determine if current debts can be paid when due.
The profitability ratios assist in determining management’s strength in earning a return on resources by controlling expenses.
Efficiency ratios measure how well assets are controlled by management. In addition, the efficiency ratios help determine the capital required to generate a certain level of sales.
Each ratio consists of numbers taken from the business’ monthly or annual financial statements (balance sheet and income statement). A mathematical equation is used to determine the ratio result. The result is then used by comparing ratios of other similar businesses, the industry, and historical ratios of the business.
The ratios should inspire questions from management, such as, “Does this result match what financial experts say it should be?” “Is it in-line with current trends?” “How does it differ from last year?” “If costs are lower, how will it impact assets?”
Ratios are an important management tool, however; one must be careful when comparing the results.
The same time period should be used if comparisons are made with historical data. The comparison is not accurate if month three is compared to month four and the business is seasonal. When a comparison is made to a similar company located in a different, larger city; then the ratio should be adjusted to allow for differences between the two businesses. In other words, compare “apples to apples” and not “apples to oranges.”
Each ratio alone is not sufficient to make a management decision. A business owner can make educated strategy decisions when the ratios are analyzed together. Ratios are invaluable when used often and a baseline is determined.
The results can identify potential problems, help manage the bottom line, and effectively control cash flow.
Sandra Taylor-Sawyer is director of the Small Business Development Center at Clovis Community College. Call the center at 769-4136 or visit www.nmsbdc.org/clovis