One way to analyse the financial health of your company and identify how it might be improved is by looking closely at your financial ratios. Ratios are used to make comparisons between different aspects of a company’s performance or how the company stacks up within a particular industry or region. They reveal very basic information such as whether you have accumulated too much debt, stockpiled too much inventory or are not collecting receivables fast enough.
Ideally, you should review your ratios on a monthly basis to keep on top of changing trends in your company.
Although there are different terms for different ratios, they fall into 4 basic categories.
- Liquidity ratios
These measure the amount of liquidity (cash and easily converted assets) that you have to cover your debts, and provide a broad overview of your financial health.
- Efficiency ratios
Often measured over a 3year period, these give additional insight into areas of your business such as collections, cash flow and operational results.
- Profitability ratios
These ratios are used not only to evaluate the financial viability of your business, but are essential in comparing your business to others in your industry. You can also look for trends in your company by comparing the ratios over a certain number of years.
- Leverage ratios
These ratios provide an indication of the long-term solvency of a company and to what extent you are using long-term debt to support your business.
Ratios will vary from industry to industry and over time. Interpreting them requires knowledge of your business, your industry and the reasons for fluctuations.
It’s important to keep in mind that ratios are only one way to determine your financial performance. Beyond what industry a company is in, location can also be important. Regional differences in factors such as labour or shipping costs may also affect the result and the significance of a ratio. Sound financial analysis always entails closely examining the data used to establish the ratios as well as assessing the circumstances that generated the results.
Andrea Moody – Presenter for Pathways Australia