Financial ratio analysis is the use of standardized measurements of the financial health of a business or organization. The ratios provide a simple way to compare businesses and are the starting point for any evaluation. How can you use financial ratio analysis in your own business? There are two broad ways that it can help you:
- You can use financial ratio analysis to evaluate your own business to know what others will think when they decide to do business with you.
- You can use ratios to evaluate companies or businesses that you do business with to evaluate their ability to pay you for products or services that you provide, or to be there to complete commitments that they make.
Financial ratios can be particularly useful when you decide to extend credit to other organizations. Ratio can include the following categories:
- Liquidity – does the other organization have adequate cash on hand to pay their bills?
- Profitability – do they make money or are they in danger of going out of business.
- Debt and capitalization – are they a business that is not overburdened by debt and do they have enough capital to conduct their business affairs.
- Cash flow – is there enough cash actually flowing through the organization to make them likely to have enough to pay you.
In each of these categories there standards for the industry that will allow you to determine if the organization is one that you want to do business with and whether they are likely to be able to pay you within the terms of the sale.
Further, there are instances when you ask an outside entity to perform a specific task for you. Construct a building, provide a marketing service or host a website. In those instances you need to know if the other company will be around to perform the task that they have committed to. Financial analysis will provide you with a measurement of their financial strength and how likely they are to be there when you need them.
Just as you need to know how strong another business is when they deal with you, there are others that will look at your financial strength. In addition to the categories above, there may be other ratios that are used to evaluate your business, particularly ratios used to make an investment decision:
- Price/earnings – the ratio of the price of your stock to the earnings per share is a key measurement.
- Cash flow – the actual cash generated by your business after taking into account all noncash expenses and deferred items.
- Cap rate (capitalization rate) – the total value of your organization compared to the cash generated by the business
- Dividend yield – the cash paid out to owners.
- Market value/book value – Does the market value of the stock in your company compare to the recorded book value.
Keeping track of the rations that describe your business will let you stay abreast of the value that others will determine. Should you decide that you are in the market to sell your business; this knowledge will make it easier to talk to agents that can help you in the process. Knowledge is the first step toward a satisfactory deal.
Financial ratio analysis is the language that is used to measure other companies. Whether it is used to determine if you want to conduct business with another firm, or you are using it to know just what your company is worth, it is the language used by financial professionals as they make judgments about value and future.
The Turnaround Group can help you with Financial Ratio Analysis. See more details about how.