When working with their accountant, business owners are able to use ratio analysis to pinpoint strengths and weaknesses in the company. This in turn leads to more confident decision making when it comes comparing and weighing up different improvement strategies.
There is a common misconception that all financial accounting tools for business decision-making are complicated. However, a ratio is nothing more than one number in relation to another. They have the very practical property of reducing a relationship to a single number no matter the size of the two numbers involved. For example, the ratio of 2:1 can be derived from the number 20 divided by 10, or 200 divided by 100, or 200,000 divided by 100,000. The ratio does not take into consideration size; it is the relationship that is important.
Great examples of ratios can be seen on the sports field. Take cricket for example, where the strike rate of a batsman means the number of runs he scores per 100 balls faced. This allows us to compare the effectiveness of a relatively new batsman with one that has been around for many years.
The big question that arises is “which relationships to measure?” There are many possibilities and some will be more relevant in certain situations and businesses than others.
For example, in the case of a business seeking further investors, the long term earning power of the company becomes important. Meanwhile a bank will be more interested in liquidity because they want to ensure payback of their short-term debt.
The four ratio categories
There are four ratio categories:
- Balance sheet ratios
- Profitability ratios
- Overall efficiency ratios
- Specific efficiency ratios
How to use ratios to aid business decision making
Generally speaking, there are there are two key ways your business should be using ratios to evaluate the health of your business:
- Compare your business’ current performance to your performance in prior years (trends)
- Compare your business’ current performance to others in your industry (benchmark)
Remember you operate and manage your company with limited resources, management, capital and time. You can’t fix current problems or spot developing ones unless you know where to look. This process we’re describing is merely an efficient, effective method to keep your finger on the pulse of your company. The important thing to remember when working with ratios is to only calculate enough information to get the job done, but not so much as to make analysis overly confusing. You need avoid paralysis from analysis.