It is imperative for a business owner to be ‘on top of things’ and constantly evaluate the performance of the business, irrespective of the size of the business – it could be a small printing business or a mammoth multi-product conglomerate. Business performance, though it may seem great in absolute terms, always has subjectivity involved and it is crucial to compare it industry competitors & established industry benchmarks. It is here that financial ratio analysis comes in handy.
The purpose of this post is to introduce the subject of financial analysis to small businesses, entrepreneurs and young managers, especially the significance of financial ratios.
What is financial ratio analysis?
Financial ratio analysis is the selection, evaluation and interpretation of financial data in easier to understand ratios, which have been identified as critical indicators of financial performance of the business and can be used for strategy and decision-making. Financial ratio analysis is popularly used to compare a firm’s financial performance over a period of time (trend analysis) or to assess performance in comparison to other businesses.
Categories of financial ratios
Financial ratios can be grouped into categories which highlight the various facets of a firm’s financial health and operational efficiency. Some of the categories of ratios are given below:
• Leverage Ratios disclose to what extent debt is used in a firm’s capital structure.
• Liquidity Ratios present a firm’s short term financial situation or solvency.
• Operational Ratios present a firm’s operational efficiency & asset utilization.
• Profitability Ratios indicate the return on sales and capital employed.
• Solvency Ratios measure a firm’s ability to generate cash flow and honor its financial obligations.
In our next post, we’ll take up Leverage Ratios in more detail.